What could have gone wrong at Constellation?

BALTIMORE, MARYLAND - You leave the Web for 12 hours and look what happens. Who would have thought the financial world’s next holy guacamole moment would happen in Baltimore?

Obviously a potential ratings downgrade has triggered a Constellation Energy liquidity crisis – or vice versa. Translation: Rating agencies, shareholders and lenders fear it may run short on cash to carry out day-to-day operations. But we have no idea what’s causing it yet.

What’s clear is that Constellation’s reliance on borrowed money is putting it in dire straits. Much like many Wall Street firms that have run into problems, Constellation uses short-term loans to play the markets – in its case, mainly commodities such as wholesale electricity and natural gas. A huge portion of its profits – we don’t know exactly how huge – has depended on this play.

Two things could have gone wrong: 1) A critical trading blowup or 2) A perception by shareholders, lenders and rating agencies that the cheap, easy money Constellation needs to play the market won’t be there in the future.

What’s a trading blowup? When you make a bad bet, lenders demand more collateral. When you make a really bad bet, you run out of collateral to post, which causes lenders to pull the plug, which threatens the whole enterprise.

We don’t know that this is what’s going on. But it’s one explanation given the plunge in Constellation’s stock and the company’s apparent decision to put itself up for sale.

Constellation had wagered on rising energy prices through the first half of the year. It was the right bet, and profits looked good at the end of June. But in July energy started to crater. If Constellation remained “long” energy after July, that might help explain what’s going on. But it’s speculation.

The alternative scenario is that Constellation lenders are simply declining to roll over its loans in order to lower their risk, and it’s snowballing. One lender makes a prudent move. A rating agency starts to worry. The second lender worries a credit drought will hurt Constellation’s liquidity, and it becomes self-fulfilling.

There has been much worry that Constellation was owed money by Lehman Brothers or AIG or some other firm that just collapsed. Constellation said the Lehman collapse wouldn’t cause it any problems. And AIG got bailed out last night, so it is honoring its commitments. In any event, it’s hard to imagine that such “counterparty risk” could threaten Constellation enough to seek to sell itself.



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