BP’s Oil Spill Damages: What Exxon Valdez Wrought

June 12, 2010 at 5:00 PM Leave a comment

An interesting question is how BP will finance its ultimate oil spill liability damage obligations, assuming the $75 million federal law cap is exceeded (either successfully removed for a continuing tort, or via state law claims, which are not pre-empted by the federal Oil Pollution Liability and Compensation Act, 33 U.S.C. 2704 (a) (3, 4), damage cap).   No one knows what the final amount of damages, fines and penalties might be—too many unknowns—but some commentators are tossing around $40 billion, all told.  That’s a lot of money, even for BP.  Some are asking, “Does it have the assets to survive?”  Lawsuits are already being filed, and Attorney General Eric Holder has announced a criminal investigation.

According to a fascinating retrospective review of financial-crisis books in the June 1, 2009 New Yorker, the now-maligned collateralized debt obligations (CDOs) were borne of Exxon’s need to finance damage payments for its Valdez oil spill.

Reviewer John Lanchester writes that when Exxon needed credit to cover $5 billion in damages resulting from the 1989 spill in Prince William Sound, Exxon asked its banker, J.P. Morgan, to help.  J.P. Morgan was reportedly reluctant to turn down its old client, but also didn’t want to tie up that much cash in reserve.  (Banks hold 8% of their capital in reserve against the risk of outstanding loans.)  So J.P. Morgan came up with the idea to sell the credit risk of the Exxon damages to the European Bank of Reconstruction and Development, and paid the EBRD a fee for taking on the risk, of being on the hook, so to speak if Exxon defaulted.

This type of deal allowed J.P. Morgan to shift risk off its books, generate income, and keep its capital free to loan out for other activities.  The deal was so new in 1994 that it didn’t have a name until one was invented for it: “credit-default swap.”  Ultimately, the name changed to collateralized debt obligations (CDOs).  The credit risk swapping deal became institutionalized, with investment banks bundling large amounts of risk for sale.  The trick was to assess the risk of default and price the deal appropriately.  In hindsight, the investment banks failed to accurately assess, or price, the average of the bundled risks, especially those related to mortgage backed loans.  When housing prices fell, mortgage backed securities and CDOs, an innovation which allowed investors around the world to buy into America’s real estate, were blamed for the result: a liquidity crisis.   Some banks failed, all tightened credit, and the economy went into a tailspin.

A lot of very basic banking rules had been ignored.  Some Depression-era regulations on banks, investments and insurance firms that had been wiped out in the 1990s’ irrational exuberance, might have helped, though it’s not clear how much.

Anyway, BP’s out-of-pocket costs for the April 20 Deepwater Horizon spill so far are reportedly $1 billion.  With its stock trading at 1997 levels, BP has lost about $80 billion in market value.  However, BP has huge assets to meet its liabilities; its market value was still $105 billion on Fri, June 11.  And BP can always look to Transocean, from which it leased the oil well that exploded and sank, Halliburton, and others, to chip in.

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