Is AOL-Time Warner ignoring their interest rate exposure, or merely managing it in a way that avoids disclosure?

As one of the component companies in the 'Portfolio of 33' we are obliged to focus some attention on what, at first glance, may be perceived to be AOL-Time Warner's lack of disclosure into some of the details regarding risk management under FAS 133 accounting. Is it a fair question to ask why this company, with a market capitalization of $157 billion and net debt in excess of $19 billion, would not make use of interest-rate derivatives of some kind to modify that interest rate exposure?

Or, if they do make use of interest rate derivatives for risk management purposes, why is there no mention of it in their quarterly reports, which in accordance with FAS 133 requires that derivatives used for hedging activities be recorded at fair value?

These questions are all the more interesting when we consider the relationship Time Warner has had with the FASB's DIG: two of its recent assistant controllers were not only former SEC accountants, but observing and/or regular members of the DIG: Steve Swad and Pascal Desroches. We should assume, then, that AOL-TW might serve the financial reporting community as a paragon example of FAS 133-related financial reporting.

Are we just being impatient?
In fairness to AOL-TW, what they left out of recent quarterly reports they partially made up for in their last annual report for 2000. Under the heading QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK, for example, it states: America Online is exposed to immaterial levels of market risk related to changes in foreign currency exchange rates and interest rates." The bulk of the company's exposure, per the 10-K, concerns its investment portfolio. "America Online is exposed to market risk as it relates to changes in the market value of its investments. America Online invests in equity instruments of public and private companies for business and strategic purposes, most of which are Internet and technology companies." Accordingly, the derivatives used to hedge this exposure get the bulk of the FAS 133-related attention in the company's financial reporting.

But is their interest rate risk really that immaterial? The third quarter 10Q reports as September 30, 2001, AOL Time Warner had $20.7 billion of debt and $1.5 billion of cash and cash equivalents for a net debt of $19.2 billion.

Fixed vs. Floating
It's not clear from the financial statements how much of the $19.2 billion outstanding debt is in fixed rate and how much is floating, but AOL-TW's web site itemizes some twenty six separately issued notes and debentures mostly by Time Warner and its consolidated subsidiaries, with remaining maturities of five, ten, twenty and thirty years (14.36 years on average), with an average coupon of 8.12%. This listing though doesn't provide the amounts issued per cusip so it is not possible to tell with any precision what the total amount of fixed rate debt is for the combined companies, and unfortunately, AOL-Time Warner treasury staff declined to comment on any of this publicly available information.

The company's 2000 10-K explains that a Bank Credit Agreement was in place permitting borrowings of up to $7.5 billion for general business purposes and in support of commercial paper borrowings of which amounts totaling $6.8 billion had been drawn down by Time Warner and its consolidated subsidiaries as of December 31, 2000. By April of 2001, AOL-TW had established a $5 billion commercial paper program allowing the company to issue commercial paper to investors periodically in maturities of up to 365 days for general corporate purposes including investments, capital expenditures, repayment of debt and financing acquisitions. However, it is still not quite clear from the public disclosures just how much of this program has been utilized to date.

Opportunity risk
Nevertheless, a cursory estimation using a rough metric suggests a ratio of about 65% to 35% of fixed rate vs. floating rate debt, a ratio that might be considered less than optimal during a quarter when the federal reserve cut the fed funds rate by 100 basis points and ten year swap rates fell by a corresponding amount. Assuming that 65% of AOL-TW's debt was fixed, at an average maturity of 14 years and at an average coupon rate of 8.12%, a drop in yields on that debt of 100 basis points implies a fair value change in present value terms of close to $1.2 billion. Not that they would want to eliminate all of their fixed rate debt, but if half of it was converted to floating via fixed to floating swaps, they still would have saved themselves a significant amount from the lower funding cost. Did that 10K really say company's exposure to interest rates was immaterial?

Debt and deflation
Clearly, the risk to AOL-TW's fixed rate liabilities from falling interest rates is not one that negatively affects their cash flows, except in as much as it represents an opportunity loss. If the economy has entered a period of deflation as some analysts have argued, debt becomes progressively harder to service. This means that companies who are net debtors will be better able to weather the deflation if they are in a position to benefit from the falling interest rate environment and garner a lower cost of funds.

Economist David Gitlitz at TrendMacrolytics argues that monetary velocity, which measures the turnover rate of money in the economy has been falling, reflecting a rising demand for money relative to goods sold for it. He reports that velocity fell for the fifth consecutive quarter in the June-September period dropping more 6% in the past year.

According to Gitlitz, "With nominal output essentially serving as a proxy for corporate revenues and earnings, the risk to current market prices of a Fed that fails to get ahead of the deflation curve is becoming all too apparent."

Equity risk is another story
As noted above, equity investments clearly have a different priority for AOL-TW as this exposure is featured in both the 2000 annual report and in the recent 10-Q's. As of the year-end 2000, AOL-TW reported equity holdings classified as available for sale securities including restricted securities, derivatives and hedged securities at a fair market value of $1.206 billion relative to a cost basis of $1.105 billion.

The third quarter 10-Q highlights recorded non-cash pretax charges of $620 million, $54 million and $147 million respectively in the first three quarters which reduced the carrying value of "certain publicly traded and privately held investments and restricted securities" that incurred "other-than-temporary declines" in market value. Presumably, "other-than-temporary declines" implies that the declines are likely to be permanent.

The third quarter 10-Q also reports that the second quarter charge of $54 million was almost entirely offset by pretax gains related to derivative d the sale of certain investments. These charges were included in other income (expense), net, in the accompanying consolidated statement of operations for the three and nine months ended September 30, 2001. The gains for certain of the derivatives that classified as cash flow hedges were included in other comprehensive income, and presumably these hedges were highly effective.

However, getting back to the question at hand, why does AOL-TIME Warner attach so much significance to the market risk associated with their equity investments in other companies while choosing to ignore their interest rate risk? To put this question in context, consider the $147 million third quarter charge to earnings from losses on such equity investments and compare it to the potential billion dollar-plus opportunity loss the company may have faced due to the drop in interest rates during the third quarter. Analysts may wonder: Does AOL-Time Warner have its risks in perspective?