What’s happening with Glencore is an eerie, picture-perfect replay of what happened in the AIG meltdown of 2008.
This September 17, 2008 file photo shows the logo of American International Group Inc. outside their office in the lower Manhattan area of New York. AFP PHOTO / Files / Stan HONDA
And what happens next will rock the entire market.
On Monday, Glencore’s London-listed shares had collapsed by more than 80 percent from a 52-week high of 345.69 pence ($5.25) to open at 97p ($1.47), as investors have lost confidence in the company.
But during Monday’s trading, shares fell another 29 percent to 68p ($1.03). Even more ominously, the credit markets are now questioning whether the company can survive the carnage in major commodities markets, which is battering the company’s earnings and threatening its investment-grade credit rating.
Investors are fleeing Glencore’s bonds as well. Its €1.25 billion ($1.4 billion) of notes due March 2021 fell to 78 on Monday, while its €750 million ($842.44 million) of bonds due March 2025 have dropped to 67, both record lows.
Glencore faces a number of big problems…
Here’s What’s Wrong with Glencore
First, its earnings are plunging on the back of lower commodity prices. Sales have declined from $240 billion in 2013 to an estimated $162 billion this year. Net income has fallen from $4.3 billion in 2013 to an estimated $1.47 billion this year. That might still sound like a lot of money, but not when you are carrying over $45 billion of debt ($30 billion net of cash) like Glencore is. The company’s interest bill will be about $1.25 billion this year. It simply has no further margin of error if commodity prices fall any further, which they are likely to do.
The company is fatally vulnerable to a weakening global economy and what that means for commodity prices – every 10 percent drop in copper lowers EBITDA (cash flow) by $1.2 billion. Glencore is facing a toxic mix of too much debt and crashing commodity prices, and there is no way out unless commodities stage a miracle rally – which isn’t going to happen.
But there’s an even bigger problem facing the company...
Glencore carries $19 billion of derivatives on its books. If Glencore loses its investment-grade rating – which is a virtual certainty – it will be required to post additional cash collateral for these contracts. And the company doesn’t have enough cash to do that.
If this sounds familiar, that’s because it’s very similar to what happened to insurance giant AIG in 2008 at the height of the financial crisis. AIG had written hundreds of billions of credit default swaps on subprime mortgage deals. When it lost its investment-grade rating and was required to post additional cash collateral for these contracts, it was unable to do so and had to be bailed out by the U.S. government.
Before that happened, the price of credit insurance on AIG blew out.
And that’s exactly what’s happening to Glencore now.
The World’s Largest Commodity Trader Is at a High Risk of Default
For healthy companies, credit insurance is priced in terms of an annual payment that ranges between 100 basis points for investment-grade companies to several hundred basis points for junk-rated companies. Credit insurance for companies considered to be in financial trouble also includes an upfront payment that ranges from 100 basis points to several hundred basis points.
For the first time since the financial crisis in 2009, sellers of credit insurance on Glencore are requiring an upfront payment in addition to the annual insurance premium. That is a terrible sign. Based on the latest data available, it costs 875 basis points a year, including the up-front payment, to buy insurance on Glencore, which equates to a 54 percent chance that the world’s largest commodities trading firm will default.
To put that in perspective, 875 basis points is where a B- rated company trades – which is six levels below investment grade.
In other words, the market has already decided that Glencore no longer deserves its investment-grade rating. It’s only a matter of time before the credit rating agencies, like Moody’s and Standard & Poor’s, catch up. Once that happens, the next problem will be whether Glencore can post enough collateral to keep these derivative contracts in place or whether it will default on its $45 billion of debt and $19 billion of derivatives.
In press reports, “sources close to Glencore” claim the company has enough liquidity to meet its obligations.
But if you go back to 2008 and read similar press reports about AIG and Lehman, those ever-helpful “close sources” said the same thing about those two companies.
If you want to know what’s going on, pay attention to what the markets are saying, not what these so-called “sources” are saying.
Defaulting on $64 billion of debt obligations is bad enough. But the story doesn’t end there.
$155 Billion Is Serious Money with Serious Consequences
Glencore doesn’t exist in a vacuum today, just like AIG didn’t exist in a vacuum in 2008.
Glencore is an essential link in a networked global financial system. It is an important counterparty to many of the largest financial institutions in the world, who are in turn counterparties to other financial institutions, who are in turn counterparties in an endless chain of relationships that keep the global markets operating.
And the global counterparty chain is only as strong as its weakest link. In 2008, its weakest link was AIG, until the government stepped up and bailed out the insurer. Then the weakest link became Lehman Brothers. When the government refused to step up and bail out the brokerage firm, all hell broke loose.
Fortunately, Glencore is a lot smaller than Lehman Brothers, with a balance sheet of $155 billion compared to Lehman Brothers’ $600 billion in 2008 when it went belly-up.
But $155 billion is still a big mess to clean up. And Glencore is connected to a lot of other counterparties who will have to scramble if it collapses.
A Glencore bankruptcy will be a disaster for markets that are already on the run. This situation could deteriorate quickly – and rock the markets.
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