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The World According to Jerome Lienhard

As corporate treasury manager at Toyota Motor Credit Corp., Jerome Lienhard ranks as one of the country’s biggest and most sophisticated issuers. He is responsible for the management of all of TMCC’s treasury activity, including funding, cash management and risk management. Since joining Toyota in 1981, he has held a variety of accounting, corporate finance, operation and treasury positions within the company. He holds a bachelor of science degree in accounting and an MBA in international finance from the University of Southern California. He spoke with editor Joe Kolman last December.

Derivatives Strategy: Toyota Motor Credit is one of the largest corporate issuers in the U.S. market. How does risk management fit into your goals?

Jerome Lienhard: Ultimately, the goal of our captive-finance company is to facilitate the sale of Toyota cars in the United States at a competitive and steady rate. I need to provide the lowest possible cost of funds for that effort with the least amount of volatility.

DS: It would be no good to offer consumers a low rate in September or October and then change it in November?

JL: That’s exactly right. We want the variability in our funding costs to have as limited as possible an impact on the rates we charge consumers. For that reason, for example, we’d never sell a lot of options to reduce our funding costs, because that would cause a lot of volatility. We don’t view treasury as a profit center, and we’re not in a big trading mode here.

The goal is to access global liquidity with the best rates available, given our credit rating, and with a lack of negative volatility. The Federal Reserve and the U.S. economy have accommodated both of those goals in the last few years. Short-term interest rates had been stable in an unprecedented way, and until fairly recently, our access to liquidity has been spectacular. We have been able to issue in the eurobond market at single-digit spreads to Treasuries.

DS: What has happened recently to change that?

JL: In the last year or so, starting with the Thailand meltdown, the Asian crisis in general and the increased scrutiny of anything Japanese, we’ve seen our new-issue spreads deteriorate significantly. But despite the problems in the capital markets, U.S. car sales at Toyota have been better than they’ve ever been. My first goal is to make sure we have access to liquidity so that we can fund those sales here in the United States.

We’re looking across all available markets. That means commercial paper and the privately placed medium-term-note markets, either in euro or domestic form. It also means the eurobond market across every currency available, as well as the U.S. dollar market and the U.S. domestic bond market. We also have a fairly large asset securitization program that enables us to securitize about $1.5 billion to $2 billion of assets, which we sell off-balance sheet in order to maintain our targeted debt/equity ratio.

To do all that, we engage in a proactive dialogue with investors when we can, and with our financial intermediaries as well. We generally try not to overprice a transaction. Instead of trying to extract the last possible basis point, we allow for price and performance, because we’re in the markets on a regular basis.

DS: How much do you issue yearly?

JL: Our funding program is about $7 billion a year. That puts us in the same league with Chrysler and some of the other big credit card issuers. GMAC, Ford and GE Capital Credit are slightly larger, but, historically, we’re the second-largest corporate borrower in the eurobond markets, behind General Electric.

“If you decided to account for any risk that could happen all the way out to six standard deviations, you wouldn’t be able to see any of the minute changes that happen day to day.”

DS: Do you take on any currency risk in these transactions?

JL: We access all the various currencies but we swap everything back to dollars. In all of our assets, our loans and leases to U.S. consumers or loans to dealers, we run no currency exposure.

DS: What about on the interest rate side?

JL: All of our assets are fixed-rate amortizing loans, which is the convention in the auto finance markets. So if we take on variable-rate funding, we’re exposed to interest rates.

We have a firm belief around here that, over the long run, the yield curve is normally shaped and that floating-rate debt will cost less than fixed-rate or long-term debt. To hedge ourselves, we borrow on a floating-rate basis, or borrow fixed and swap everything to floating rate. Then we go out and purchase caps on the London Interbank Offered Rate.

We set the strike rate of the cap at whatever the swap rate would be for that tenor. If it were a three-year cap on 90-day Libor, we would set the strike rate on the cap at the swap rate. About 52 percent of our total debt portfolio is protected by interest rate caps.

DS: How did you come up with the 52 percent number?

JL: Historically, we’ve ranged between 40 percent and 70 percent. It’s based on our own internal simulations, and on how much volatility we’re willing to take, and how much earnings we’re willing to put at risk over the course of a year. We usually run at about 60 percent, but over the last year or so we’ve been moving that number down because we see less and less fundamental risk of increased interest rates in the United States.

We think we’re in a global disinflationary environment. But because we realize we could be wrong, we still hedge against rates going up. At the moment, we’re actually trying to determine what we think the optimum amount of fixed-rate funding or capping would be. We think 52 percent may be too high.

We want to hit a certain return-on-equity bogey within a certain confidence interval based on historical rate volatility. We have a covenant in the operating agreement with our parent that requires that our operating income be a certain multiple over our expenses. We don’t ever want to drop below that, because then we’d have to get an equity contribution from our parent. Although we’re willing to take on some interest rate risk, we don’t want to have any interest rate exposure that would trigger an equity contribution.

Right now, we’re in the process of developing interest rate scenarios and bottom-line scenarios in order to simulate our net income in a variety of different situations. Then, we will try to pick an optimized position on that efficient frontier for what the hedging should be.

DS: How do you measure the risks in your portfolios?

JL: We use value-at-risk. We take all the cash flows of our assets and liabilities and discount them back to present value. Then we go through that dynamic a thousand times to simulate a distribution of the net present value of our portfolio. The VAR determines that the loss of net present value in our portfolio of a two-standard-deviation adverse move in interest rates over a 30-day period would be X.

DS: At least X. It could be more.

JL: Yes, within a 95 percent confidence interval, the maximum loss that we will take in value is $100 million over a 30-day period, or essentially 5 percent of our capital, which is $2 billion. The VAR doesn’t give the maximum loss, and we don’t really look at the maximum loss beyond two standard deviations.

DS: What happens if you get a really big fat-tail event, or if something comes out of left field?

JL: In our case, what’s driving the variability is essentially the Fed Funds rate or the commercial paper rate or Libor. To go beyond two standard deviations, Libor’s got to go up about 150 basis points. That’s a fairly unlikely scenario, but if it did happen, we could respond pretty quickly.

DS: The question then becomes: Why are you using VAR? What’s the rationale?

JL: If you used value-at-risk for less predictable variables, like exchange rates or equity prices or other yield curves that move more dramatically, you’d get much bigger swings. I realize that VAR doesn’t take fat tails into account. We’ve done some subjective evaluation about what fat tails in short-term U.S. interest rates would be. We’ve also evaluated our ability to recognize that scenario and move to offset that within our 30-day holding period.

DS: What would happen if you pushed your confidence interval to 100 percent?

JL: We could also lengthen our holding period as well. The problem is that when you do either of those things, it’s difficult to get a precise number that helps you make decisions day to day. If you decided to account for any risk that could happen all the way out to six standard deviations, you wouldn’t be able to see any of the minute changes that happen day to day, because you’d be pulling in everything that could possibly happen.

DS: Give me an example of how your VAR methodology affects your daily decisions.

JL: It affects them quite dramatically. Before we did this, our rule was to hedge so that 60 percent of our debt would be fixed rate. If interest rates moved 15 basis points, for example, we knew we had to do $200 million worth of hedging in the next two weeks. Then we’d say, “We think the three-year looks really good, so we’re going to do a three-year fixed-rate swap, where we pay fixed rate for three years because that’s what the average life of our assets is.” A car lease is about three years.

“I’m not sure people ever expected that decisions made by politicians in Russia would have an impact on their ability to get a second mortgage. However, that is exactly what happened.”

Then six months later, by gosh, rates would have come down and the decision that seemed so brilliant at the time wouldn’t look so brilliant—because we had locked ourselves into that three-year yield curve.

When we introduced VAR into our process, we also began hedging using interest rate caps rather than fixed-rate debt. We now match the maturity of the caps with that of our assets. In so doing, we reduce the VAR resulting from an increase in rates and retain all the upside potential from declining rates. In other words, we create an asymmetric risk profile. Rather than take any view on rates, the caps are the choice of least regret, if you will. By matching precisely the life of the caps with the maturity of our assets, the VAR is reduced.

We’ve also enhanced our asset/liability-management tracking system. We can now put in prepayment assumptions and aggregate all of our asset maturity profiles by month, including prepayments on our loans and leases, and match that up with the debt. So we can now look at all of our assets and liabilities by quarter and maintain a fairly strong discipline in terms of when we do our hedging.

For example, if we know that we want to maintain a 55 percent hedge ratio, we want that to apply to each quarter (or month or day, ideally) rather than only to the aggregate portfolio. Therefore, we can determine the amount of hedging we need to do as we add assets—and we stick with that discipline rather than trying to time interest rate movements. It is this matching discipline that really has a positive impact on our VAR.

Now we hedge 52 percent of our debt every month or quarter and don’t make any sort of bets about where rates are. If the hedged amount of debt ever falls below 52 percent for a certain quarter, then that’s when we do our next piece of hedging. The result is that we do a lot less hedging than we did in the past, and we are spending a lot less money.

DS: By how much have you reduced your hedging expenses?

JL: By about $10 million to $12 million a year, or about 20 percent. The VAR calculation in the portfolio has also gone down significantly. When we first put it in place, the VAR in our total portfolio was about $85 million; today it is $25 million.

DS: What about stress testing?

JL: We go through that exercise several times a year. If rates go up dramatically, What would the impact be? That’s why we use the caps—to create asymmetry. We can’t protect ourselves completely against a meltdown scenario in interest rates, but for any movement in rates, either positive or negative, we want the upside to be worth more than the cost of the downside.

“Economic fundamentals are meaningless in times of crisis. The dramatic deterioration in credit spreads last September and October had nothing to do with the fundamentals of corporates.”

We don’t have this thing completely right. We can get more precise measures of risk, and we understand the shortcomings of value-at-risk. Quite frankly, we’re not sure we’ve completely fleshed out all of the ramifications of an inverted yield curve over the long run. How, for example, do you use options in an inverted yield curve where short-term rates are higher than intermediate-term rates? We have a lot of internal academic debate about that. We haven’t had an inverted yield curve since the early 1990s, and a lot of people just write it off and say “this isn’t going to hold.”

But apart from that, we think this is the way to go. Our VAR at the end of September 1998 was $32 million. That’s about 1.4 percent of our capital, so that’s well within our target. The VAR number is another indicator that our 52 percent hedging ratio is too high. As we become more efficient at these things, we think we’ll be able to do less hedging and still have the same risk.

DS: What, if anything, have you gained from the market turmoil we have experienced this fall?

JL: I think I’ve learned three things. First, that markets are much more interconnected than anyone ever thought they were. This may seem obvious, and globalization has been a buzzword for a long time, but I’m not sure people ever expected that decisions made by politicians in Russia would have an impact on an American’s ability to get a second mortgage on his or her home. However, that is exactly what happened. Communication, the search for yields and derivatives have tied all financial markets closely together—and the speed at which information is integrated is unbelievable.

Second, economic fundamentals are meaningless in times of crisis. The dramatic deterioration of credit spreads last September and October had nothing to do with the fundamentals of corporates, and the difficulty in funding in the A2/P2 market, which was acute for a few days and has remained tough, showed just how fragile the markets can be.

Third, liquidity is king. Whether it is the used-car market or the securities market, an asset has value only if there are people willing to pay for it. The market liquidity completely dried up last October and the pain was quite severe. I am not sure what conclusions to draw from these lessons, but I think they are important to keep in mind as anyone makes decisions in the future.

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