1. 1 COLLATERAL – NOT JUST CASH AND LC’s ANY MORE J. Scott Davis Dynegy Inc. jonathan.scott.davis@dynegy.com Mike Deluca One Source Risk Management and Funding, Inc. mike@onesourcerm.com 281.240.3100 Craig R. Enochs Jackson Walker L.L.P. cenochs@jw.com 713.752.4315

2. 2 What Movie is This? A young lady is transported to a surreal location and kills the first woman she comes in contact with. She then meets up with three perfect strangers and kills again.

3. 3 In Billions of Dollars As more speculative- grade corporate debt and commercial real estate loans come due… © New York Times

4. 4 … the U. S. government also will be borrowing record sums. New borrowing that will have short- term maturities is not included. © New York Times In Trillions of Dollars

5. 5 Credit Risk mitigation tools: –Credit Default Swaps –First Liens –Credit Insurance –Liquidity Transactions

6. 6 Why Credit Risk Mitigation Products? –Protection against abnormal or catastrophic bad debt losses –Converts a variable cost – Reserves to a fixed cost – Premium + Client Risk Retention –Allows for increased sales without increased exposure –Allows for open terms or extended terms –Enables a lender to increase advance rate with enhanced collateral –Helps manage risk during price fluctuations

7. 7 Why Protect/Hedge Accounts Receivable? –Accounts receivable typically represent more than 40% of a company’s assets. –The accounts receivable asset is the most vulnerable to unexpected loss and business cycles. –Few companies can compete without extending credit.

8. 8 Most companies protect against every other unpredictable event that has a high potential for loss….property, liability, business interruption….. But have no protection against excessive credit write-offs.

9. 9 What Risk Mitigation Products Are Not –A credit management substitute –Routine bad-debt protection –Trade dispute protection

10. 10 I. Credit Default Swaps 1. Settlement If a “Credit Event” occurs, Seller pays the difference between:  The face value of the Reference Obligation; and  The current market value of the Reference Obligation. Commonly documented through the ISDA

11. 11 I. Credit Default Swaps 2. Purpose  Increase or decrease credit exposure without transferring assets or obligations  Seller immediately increases its credit exposure without having to outlay any cash  Buyer immediately decreases its credit exposure without having to dispose of any outstanding obligations  Popular with banks and hedge funds because of ability to manage exposure

12. 12 I. Credit Default Swaps 3. Regulation:  Exempt from CFTC regulation because:  Not executed on a Trading Facility (Over-the-Counter)  Entered into between Eligible Contract Participants  Exempt from certain SEC regulations because:  Constitutes a “Security-Based Swap Agreement”, which is expressly excluded from the definition of “Security” in the Securities Act and Exchange Act.

13. 13 I. Credit Default Swaps 4. CDS Transactions v. Insurance Contracts  Material interest in underlying obligation  Insurance contract requires “insurable interest”  Buyer of CDS protection does not need to show any interest in the Reference Obligation  Proof of loss  Insurance contract requires insured to show “proof of loss” before amounts are paid under the policy  Seller pays Buyer CDS amounts whether or not Buyer has actually incurred any loss related to the Reference Obligation.

14. 14 I. Credit Default Swaps  Rates  Insurance contracts: Rates adjusted by insurer on annual basis  CDS Transactions: Fee remains constant throughout the term of the deal.  Termination  Insurance contract: Insured can generally terminate at will  CDS Transaction: Set term is defined in the Confirmation, so Buyer cannot unilaterally terminate. If Buyer fails to pay CDS fee, then Seller may declare Event of Default under the agreement

15. 15 I. Credit Default Swaps 5. Advantages:  Seller’s creditworthiness is substituted for the creditworthiness of the party whose obligations are secured by the CDS Transaction

16. 16 I. Credit Default Swaps 6. Risks:  Seller may become less creditworthy over the term of a CDS Transaction  Seller may fail to pay CDS obligations upon the occurrence of a Credit Event  Buyer may be exposed if it is not holding some form of collateral or security from Seller

17. 17 II. First Liens 1. Overview  Debtor has provided a first lien and security interest in a tangible asset to lenders under an existing credit facility  Debtor enters into trading agreements with hedge counterparties relating to the asset, and offers first lien as collateral  Hedge counterparty holds first priority lien and security interest pari passu with lenders

18. 18 II. First Liens 2. Advantages to Lenders:  Reduces risk  Ex: If hedge counterparty sells natural gas to run debtor’s power plant, reduces the risk that the plant will be unable to produce electricity  Increases value of the asset  Ex: If debtor sells a power plant’s electricity to hedge counterparty, this increases the value of the plant by mitigating the risk that debtor will not be able to find an economic purchaser for the plant’s output

19. 19 II. First Liens 3. 3 Types of First Lien Credit Structures (1) Replacement Structure (2) Threshold Structure (3) Tail Risk Structure

20. 20 II. First Liens (1) Replacement Structure  First lien wholly replaces any other collateral obligations of debtor under the trading agreement  Debtor not required to provide any cash, letter of credit or guaranty  Cheaper to implement than other forms of credit support

21. 21 II. First Liens (2) Threshold Structure  Hedge counterparty assigns a value to the first lien  Such value establishes a fixed collateral threshold for debtor under the trading agreement  Debtor only provides alternative forms of collateral if hedge counterparty’s exposure exceeds the threshold

22. 22 II. First Liens (3) Tail Risk Structure  Debtor initially posts collateral to hedge counterparty up to a fixed amount  The First Lien covers debtor’s “tail risk” over and above the credit limit  Debtor’s collateral obligations are fixed despite any subsequent market fluctuations altering hedge counterparty’s exposure.

23. 23 II. First Liens 4. Advantages to Debtor  No additional collateral needed  No liquidity needed  More equity may be available under Credit Agreement than in other credit structures  Lower administrative burden  More efficient use of the capital locked up in the assets of the first lien estate

24. 24 II. First Liens 5. Advantages to Counterparty  Right in tangible asset rather than contractual interest  Aligned interests with lender  “Right-way risk”

25. 25 II. First Liens 6. Disadvantages to Debtor  Hedge counterparty may demand additional collateral or price concessions  Low asset valuation for credit purposes  First liens are fairly illiquid and contingent upon terms of a Credit Agreement or actions by lenders  Requires positive multiple of equity to debt on assets in facility

26. 26 II. First Liens  First lien places hard assets at risk that are not otherwise affected in other credit structures  Even if counterparty accepts first lien, counterparty may impose ultra conservative risk limits and parameters in the transactions secured by the first lien

27. 27 II. First Liens 8. Disadvantages to Counterparty  Highly illiquid collateral  Extended delay between default and payment  Lack of control in collateral  Acting as part of a group of creditors rather than individually  Risk if counterparty’s interests diverge from other lenders and hedge counterparties  Not fungible

28. 28 II. First Liens 9. Additional Considerations with First Liens  Voting Rights  Generally contained in the Credit Agreement  Matters on which hedge counterparty can vote (and weight of vote) often differ from lenders  Compared to lenders in the credit facility, hedge counterparty may have little or no voting power  Hedge counterparties must work with lenders because interests are linked

29. 29 III. Credit Insurance Do I need credit insurance? –Insurers like a spread of risk but will consider segment or individual account coverage. Whole Turnover / Portfolio Coverage Portfolio Hedging / Catastrophic Excess of Loss Segment of Accounts Coverage Individual Account Coverage

30. 30 III. Credit Insurance The Basic Insurance Coverage –Commercial Risk – Domestic/Export Buyer Insolvency Protracted Default Non Acceptance Contract Frustration –Political Risk – Export Inability to obtain hard currency Changes in Import/Export regulations Contract frustration due to Act of War Foreign government non-payment

31. 31 III. Credit Insurance Types of Underwriters –Limits Underwriters The carrier can help manage your business on a transactional basis. (set up to underwrite large numbers of names) –Portfolio Underwriters – The carrier will underwrite the top limits and then provide large discretionary cover.

32. 32 III. Credit Insurance Types of Insurance Coverage –Cancelable Limits Carrier assists in monitoring accounts and provides warning and guidance in the event there is increased likelihood of default –Non-Cancelable Limits Carrier will not cancel limits, but the action of the limit could cancel itself.

33. 33 IV. Contingent Liquidity 1.Characteristics –Designed to be utilized in a high commodity price environment. Mitigates tail risk liquidity exposure. –First tranche of collateral posted by purchasing company within the normal distribution of expected collateral requirements. –Committed source of funding indexed to underlying commodity prices. –Incremental funding supplementing primary sources of liquidity. –Can be structured in many forms, such as Bank Credit Facility, Derivatives, Etc…. –In other words a “Call Option” on liquidity.

34. 34 IV. Contingent Liquidity 2.Benefits –Mitigates tail risk of potential collateral calls from extreme price movements. –Protects existing positions from being unwound due to a lack of liquidity. –Provides upside potential to commercial operations to execute favorable hedges during commodity price spikes.

35. 35 IV. Contingent Liquidity 3.Risks –Can be costly. Depending upon the amount required and timing of the purchase. –Can be more administratively burdensome to credit group then primary sources of funding. Especially the bank facility structure. –Possibility exists of not utilizing contingent facility at all and not receiving value for upfront premium costs. –Events of Default for issuing Bank or Counterparty.

36. 36 IV. Contingent Liquidity 4.Considerations –Purchase of a contingent liquidity product is most cost effective when bought in preparation for a possible tail event rather than during or right before one transpires. This is applicable to the financial, commodity and credit markets. –Structure of the contingent facility should be designed to mitigate current or future transactions with correlated movement of exposure, such as a toll or large power or gas position. –Size of the facility should be tied to the Potential Future Exposure of the targeted position at which point exposures exhaust or strain the primary sources of liquidity.

37. 37 IV. Contingent Liquidity 4.Considerations (continued) –Contingent liquidity should then be indexed to an underlying commodity curve (usually gas) and become available once the indexed curve exceeds a minimum price level. –As prices increase above the minimum level the available funds within the contingent facility grow indexed to the underlying curve. Usually the facility is capped at a maximum size. –In many structures the facility availability will amortize over the term of the agreement as the PFE related liquidity position diminishes.