Collateral, credit crunch took down Constellation

The Baltimore Sun

Every one of Constellation Energy Group's 1.1 million electric utility customers can relate to the crisis that forced the company into a shotgun takeover yesterday.

Essentially, Wall Street threatened to shut off the power.

More precisely, the national rating agencies threatened to cut off the company's credit. And without credit, Constellation was on the brink of losing what it needs to keep nearly all of its multibillion-dollar operation turned on and energized.

It was a dilemma common to Lehman Brothers Holdings Inc., AIG Inc. and other financial implosions of recent days. And as Constellation showed, such a credit squeeze can undo an otherwise stable, even profit-making enterprise, at dizzying speed - regardless of its size.

"Their lifeline is a good, clean, steady flow of cheap credit," said Steve H. Hanke, professor of applied economics at the Johns Hopkins University. "And a credit downgrade is like bad cholesterol in the arteries. It cuts off the blood to the whole system."

The rapid devaluation of Constellation, which ended yesterday with a $4.7 billion takeover agreement with MidAmerican Energy Holdings, also served as a reminder that the company has morphed into far more than a power utility.

Out of $21.1 billion in revenue collected last year, just $3.4 billion came from Baltimore Gas & Electric, its regulated utility. Constellation's primary business is not delivering electricity and gas in Baltimore, but rather trading energy and energy-related contracts with banks, consumers, suppliers and other customers around the world.

"They might own a utility company but mostly they are a financial trading company, the same as you'd find in an investment bank," said David C. Shimko, an independent energy finance consultant who has worked with Constellation and many of its trading partners.

And the risks are similar, Shimko said.

As with an investment bank, Constellation's deals with its trading partners - or "counterparties" - are governed by contracts that require the company to post collateral to ensure that its deals are good. Most of those contracts require more collateral if elements of the deal change - if market conditions shift, for instance, or if the company's credit rating drops.

By example, Shimko described the hypothetical case of Constellation signing a five-year contract to buy electricity from a power plant at a fixed price. Both Constellation and the power plant would post collateral - perhaps $5 million each - to assure the other party they will stick to the deal.

Such a contract would also typically require a significant increase in collateral - say to $10 million - if Constellation's ability to pay were called into doubt - for instance, if a major rating agency lowered the company's credit rating. And while a promissory note might satisfy some collateral requirements, large rating-related increases often must be satisfied with cash.

Constellation generally has thousands of similar contracts outstanding, in hundreds of different complex designs. And so a lowered rating can place a huge strain on the company's credit, which might already include billions of dollars in short-term loans for buying and selling.

The same phenomenon - on an even larger scale than Constellation's - helped sink AIG Monday, when a downgrade in its credit rating forced the company to come up with $14.5 billion in new collateral.

The mammoth insurance company had more than enough assets to cover that amount, but it couldn't sell them fast enough. Faced with imminent bankruptcy, it had to rely instead on an emergency bailout from the federal government.

In Constellation's case, the rating firm Standard & Poor's only threatened to reduce the company's BBB credit rating Tuesday. But the potential costs were so great - $681 million for a downgrade to BBB- and $3.37 billion if the company reached noninvestment-grade, or "junk," status - that a bailout or bankruptcy became realistic scenarios.

"These companies don't go bankrupt because of losses, they go bankrupt because of a lack of cash," Shimko said. "They could be making a billion dollars on trades, but if they can't post collateral it will all unravel."

Constellation's worries started last month not so much because of instability in its business but because of questions about how much the company would have to set aside if its credit soured. When executives said they had underestimated collateral requirements in the event of a credit downgrade, S&P; promptly reduced the company's rating, from BBB+, saying the revelation showed "a lapse in the company's risk management and control process."

The downgrade required Constellation to post about $106 million in additional collateral with its trading partners.

Commodities specialists say the incident reveals how important access to cheap cash has become in today's markets - and the potential perils that await if credit gets any tighter. It shows how billions of dollars in trading can hang on the intangible concept of confidence.

"What happens when credit isn't just expensive, but when you can't even find anyone to lend cash at any price?" Hanke asked. "In today's market, I could imagine that happening."

The typical outcome in such cases, Hanke and others said, is either bankruptcy - as Lehman Brothers and other suddenly cash-deprived businesses such as Enron Corp. learned - or a "white knight" scenario, like those engineered by AIG and Constellation. Often well-heeled companies can rescue a cash-starved business with their superior credit, then buy the company at a deep discount.

Yesterday, S&P; analysts said the arrival of MidAmerican, a subsidiary of Warren E. Buffett's Berkshire Hathaway Inc., was "a potentially favorable credit development" for Constellation, muting fears that another downgrade was imminent. Mid-American agreed to invest $1 billion immediately, with the sale expected to close in mid-2009.

So the credit squeeze appeared to be averted, though not before Constellation was forced to sell itself for a fraction of the market value it had only a week ago.

"A trading company is basically in the business of following through on its promises," said Craig Pirrong, director off the Global Energy Management Institute at the University of Houston. "And if its ability to do that is called into question, the entire company can dissolve. And pretty quickly."

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