The Legal Foundations of Financial Collapse (Conclusion) #1-14

[Note:  This is the last of a series.   I recommend reading the series in order — this will require clicking here or on the “Serial1” link under categories, scrolling down to the first post (#1-1) and reading up the blog from there.  I’m experimenting, so the series available to read in pdf format on Scribd for a nominal fee.  The printable pdf is also available.]

The financial system is built on credit – but not just on credit in general: the financial system is built on the credit of banks.  Whether we are talking about checking accounts, or the asset-backed commercial paper and repurchase agreements that money market funds invest in, the liquid assets that keep our economy running depend crucially on trust in banks.  Without this trust, no one would deposit their money with a bank and money fund managers would not buy the commercial paper guaranteed by a bank or the repurchase agreements sold by a bank.

Currently Bear Stearns, Lehman Brothers, AIG, and all the other financial failures have profoundly damaged the trust on which our financial system is built.  The question we face now is what actions should be taken to rebuild the foundations of that trust.

Some hark back to Franklin D. Roosevelt and argue that he faced a similar problem and addressed it effectively by establishing the Federal Deposit Insurance Corporation, a government agency which charges banks a fee in order to protect depositors from losses.  Some claim based on this model that the role of government in the financial system is to insure creditors against losses on bank liabilities in order to prevent bank runs from causing financial institutions to fail.[1]

This approach oversimplifies our financial history.  Recall that when the FDIC was established the economy had just been traumatized by a rash of bank failures so extreme that fully one-third of all the banks in the United States had closed over the previous five years.[2] Market forces were not stabilizing the economy.  The financiers had tried and failed to rebuild trust.  So trust in government was the economy’s last hope – and it worked.

In the current crisis, market forces have never been allowed to operate.  At every hint of instability the government has stepped in to jerry-rig a solution.  Far from turning to the government as a last hope, our banks have been relying heavily on government intervention for the whole of the past two years.  Thus, the challenge we face is of a completely different nature from that faced by Roosevelt:  Our banking system is not composed of the traumatized survivors of a catastrophe, it is instead composed of spoiled children who are scared of the risks inherent in leaving home to go earn a living for themselves.

If the policy goal is to extend Roosevelt’s financial market reforms of the 1930s to the present day, then the solution is to treat repurchase agreements and swaps as securities that are subject to requirements similar to those imposed on stocks, bonds, futures and options in the 1930s.  Had large scale repo and swap markets existed in the 1930s, they would almost certainly be governed today by self-regulatory organizations that are subject to the supervision of the SEC.

Financial systems exist to manage credit risk, to evaluate borrowers and direct funds to those who are most likely to be both capable and willing to repay their debts.  For this reason, it is neither possible nor desirable to protect a financial system from losses due to credit risk.  When the safe harbor exemptions were passed, legislators were told that banks couldn’t manage the credit risk of derivatives and needed special privileges so that they could use collateral to protect themselves.

Over time a collateralized interbank lending system developed.  Forgetting their Keynes, banks put their trust in collateral to protect them against losses.  Collateral allowed them to do business with other banks which they knew were not well-managed.  It made them confident that they didn’t need to provision for losses.  Weak firms maintained a deep web of connections with the rest of the financial system, which was itself overleveraged.  And then in March 2008 the banks came face to face with the fallacy of liquidity.  As they suddenly realized that collateral could not protect them if one of their own failed, they withdrew their credit lines causing the very failure that they feared.

The solution to our current problems is to recognize that trust in the banking system can only be restored when we have banks that are no longer dependent on collateralized interbank lending, but instead are willing to trust their colleagues.  Such trust – or credit – founded on strong balance sheets and good risk management is the only secure foundation for a financial system.

[1] See for example Gary Gorton, 2009, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”

[2] Ben Bernanke, 1983, “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,”  American Economic Review, 73(3), p. 259.

What is to be done? #1-13

To address the systemic risks caused by collateralized interbank lending, it is important to discourage large financial institutions from borrowing on a collateralized basis.  For example, if large financial institutions are prohibited from entering into over the counter derivative contracts that require them to post collateral, then their counterparties will be forced to evaluate the credit risk of being exposed to them.  Since every counterparty will favor the more creditworthy financial institutions, market forces will once again function to encourage the growth of conservatively run firms.

Collateral is intrinsic to the market for repurchase agreements and this market is far too large to disrupt by prohibiting the participation of large financial institutions.  On the other hand after the recent turmoil, it should not be difficult to remove the safe harbor protection for repos of less liquid assets – effectively, it is advisable to repeal those sections of the 2005 Bankruptcy Act that apply to repurchase agreements.  The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets.  As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.

To those who would argue that collateralization is necessary in order for derivative markets to function, I observe that this claim is simply false.  Collateralization of over the counter derivative contracts was introduced in the early 1990s.[1] Thus, the market for interest rate and currency swaps grew to more than $10 trillion in notional value before collateralization of derivatives became common.[2] Clearly, collateralization is not necessary to the operation of derivative markets.

In fact, financial markets are likely to be healthier when uncollateralized contracts are the norm.  In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty.  When unsound counterparties are shunned, the business of well-managed firms grows and the business of poorly managed firms shrinks.  Thus in an environment with uncollateralized contracts the natural dynamics of the financial system will tend to reduce leverage and promote stability.  This stands in stark contrast to the dynamics generated by a financial system that relies on collateral.

While unsecured interbank lending plays an important role in financial stability, it is appropriate to require collateral when dealing with an unreliable or an unproven business partner.  As long as some derivative contracts continue to require that collateral be posted, financial statements need to give the user an idea of how the collateral situation may change over the quarter.  For example firms could be required to report the maximum amount of collateral that could be called in two scenarios (i) the most adverse pricing environment and (ii) the most adverse pricing environment that was actually experienced over the past twenty-five years.

Furthermore, if Congress were interested in more thorough reform of over the counter derivatives markets, it could repeal the derivative and repo related bankruptcy amendments of 1984, 1990 and 2005, redefine repurchase agreements and swaps as securities and rely on the 1982 bankruptcy amendment to protect the interests of repo and swaps traders.  For this reform to work repo traders would have to form a Repo Trader’s Association and register with the SEC as a self regulatory organization.  Similarly, the ISDA – or an American offshoot of it – would have to act as a self regulatory organization subject to the supervision of the SEC.  Under this scenario repos and swaps would become regulated contracts like futures and options and receive the same protections – including safe harbor under the bankruptcy code – that other regulated derivatives receive.

[1] 1999 ISDA Collateral Review, p. 1

[2] The ISDA reports that by the end of 1994 there $11.3 trillion of currency and interest rate swaps outstanding.

Evaluating Collateralized Interbank Lending #1-12

The 2008 crisis demonstrated unequivocally that when the borrower is a large financial institution, collateralized lending does not protect the lender from losses.  Without the intervention of the Federal Reserve as a lender who was willing to accept collateral that nobody else was taking, many of the largest repo market participants would have been forced to sell this collateral in order to meet their obligations.  These forced sales would have driven asset prices far below those observed in 2008 – and all the major players in the repo market would have posted much larger losses than they did.

The case of AIG provides further evidence that collateralizing derivatives fails to protect the “in the money” counterparty from losses.  Collateral calls following a rating agency downgrade of the firm drove it towards bankruptcy and precipitated a bailout in the form of a loan from the Federal Reserve.  Notably $22 billion was passed from the Fed through AIG to counterparties in 2008.  It is abundantly clear that this collateral would not have been posted in the absence of government intervention and thus, if standard bankruptcy procedure had been followed, AIG’s counterparties would have been short $22 billion on their derivative contracts.

The 2008 crisis demonstrates that the only protection a bank has against the failure of a large counterparty is the intervention of the central bank.  Because of the fear of fire sales, collateral fell in value just when its protection was most important to lenders.  Similarly, large collateral calls themselves precipitated bankruptcies – with the result that without the help of the Federal Reserve the collateral would never have been posted.  In short, collateral was worse than useless throughout the crisis, because it served to destabilize financial institutions rather than to stabilize them.

The 2008 crisis raises this question:  Is collateralized interbank lending an inherently destabilizing force in a financial system? Three quarters of a century ago J.M. Keynes expressed the problem perfectly:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities.  It forgets that there is no such thing as liquidity of investment for the community as a whole.[1]

The exemptions to the bankruptcy code for derivatives and the collateralized interbank lending regime that grew out of these exemptions are built on the fallacy that there is such a thing “as liquidity of investment for the community as a whole.”  Keynes also remarked on the most important cost created by ignoring the fallacy of liquidity:

The fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true of all investors collectively) calms his nerves and makes him much more willing to run a risk.[2]

The collateralized interbank lending regime encourages banks to believe that their collateral is “liquid”, protecting them from losses in the event that a counterparty defaults.  Adherence to this fallacy has two consequences: (i) banks do not set aside reserves or hold capital to protect themselves against losses that they cannot imagine, and (ii) banks do not monitor counterparties carefully, because they believe that they are fully protected by collateral.  Both of these consequences are extremely detrimental to financial stability:  the financial system as a whole is undercapitalized and in the absence of screening for credit risk the weakest financial institutions end up interconnected with every other firm.  In such an environment, when one firm starts to wobble the whole financial structure can easily come tumbling down.

As last year’s Federal Reserve intervention demonstrated, collateralized interbank lending only protects lenders if the central bank is willing to intervene to prevent a fire sale of collateral.  But then, what is the role of collateral?  After all, the lender of last resort has a long tradition of protecting financial systems where interbank lending is unsecured.  Collateral serves only to create the illusion of a security that does not exist.  This illusion causes banks to reduce the capital they set aside to protect against unexpected losses and to cut back on monitoring the credit risk of their counterparties.  In short, the existing collateralized derivatives regime is inherently destabilizing:  It is not designed to function in an environment where a large financial institution can fail, it tends to reduce capital levels and increase lending to weak firms, and finally, because of the safe harbor exemptions, it all but guarantees that a run on a large financial institution will take place.

[1] Keynes, 1935, General Theory, p. 155.

[2] Keynes, 1935, General Theory, p. 160.

The Financial Collapse of 2008 #1-11

This repo market instability became evident in March 2008, when rumors were swirling about Bear Stearns’ financial condition.  Counterparties did not want to risk holding collateral that could only be sold at fire sale prices in the event of a Bear Stearns’ bankruptcy – so they refused to lend to Bear against anything but the highest quality collateral.  Since Bear Stearns financed half of its balance sheet on the repo market, this withdrawal of credit was disastrous.  In the absence of credit drawn on repos Bear did not have the liquidity necessary to meet its short-term obligations.

In the case of Bear Stearns, fear of a bankruptcy filing precipitated a withdrawal of credit that made bankruptcy almost inevitable – and destroyed the firm.  In September 2008 Lehman Brothers collapsed when it too faced a bank run as fellow bankers withdrew credit and issued collateral calls.[1] At the time of the Lehman failure, Merrill Lynch was at risk of the same treatment and was saved only by Bank of America’s eleventh hour purchase.  Within days Goldman Sachs and Morgan Stanley were also at risk – exactly one week after Lehman filed for bankruptcy the Federal Reserve announced expedited approval for the transformation of these firms into bank holding companies with full access to the Fed’s support for commercial banks.[2]

In short, every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued.  Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs.  Whenever there is some small likelihood that a firm a might declare bankruptcy, counterparties protect themselves from the possibility of losses in a fire sale by withdrawing credit from the firm – and driving it into bankruptcy.  The repo markets we have now can only be described as fundamentally unstable.

The financial instability created by the run on Bear Stearns forced the Federal Reserve to take extraordinary action.  The Fed appealed to its authority under section 13(3) of the Federal Reserve Act to lend in exigent circumstances to financial institutions that were not commercial banks.  This authority was last exercised more than 50 years ago.

Using its emergency powers the Fed initiated two programs in March 2008:  the Term Securities Lending Facility and the Primary Dealer Credit Facility.  The Term Securities Lending Facility allows investment banks to temporarily trade highly rated private sector debt for Treasury securities.  In the Primary Dealer Credit Facility the Fed lends to investment banks against investment grade collateral.  Both of these programs were clearly designed to deal with the collapse of repo markets trading less liquid securities.  In addition, the Fed lent $29 billion to JP Morgan Chase to facilitate the purchase of Bear Stearns.  This loan was extraordinary because it was a non-recourse loan – in other words, JP Morgan Chase has the legal right to walk away from the loan leaving the Fed with only the collateral as payment.

As a consequence of the March 2008 collapse of the repo market, the Federal Reserve was exposed to private sector credit risk.  By the start of September it held as much as $100 billion of private sector assets that had been traded temporarily for Treasuries.  September was a disastrous month for the investments banks.  On September 14, the day before Lehman Brothers filed for bankruptcy, the Fed agreed to accept all collateral that had commonly been used in repo markets – including collateral that was not investment grade – in the Primary Dealer Credit Facility and extended the Term Securities Lending Facility to include all investment grade securities, not just those that were AAA rated.  (Lehman did not have access to these programs, because it did not meet the Fed’s criteria for a sound financial institution.)  By October 1st, the investment banks had borrowed almost $150 billion directly from the Fed.  This, in addition to $230 billion of private sector assets temporarily exchanged for Treasuries.[3]

In short, the collapse of the repo market in 2008 forced the Federal Reserve to intervene to protect the financial system by exchanging the risky assets that had been used as repo collateral for cash and Treasuries – the Fed chose in 2008 to act as a lender of last resort to the market for repurchase agreements.  As of mid-2009 these programs had shrunk to almost nothing, indicating either that the investment banks have found other sources of financing – possibly due to their new status as bank holding companies – or that repo markets have to some degree recovered.  Now that the crisis in the market for repurchase agreements is over, we can take the time to evaluate whether this is an appropriate role for the Federal Reserve or whether the repo market itself needs to be reformed.

[1] CARRICK MOLLENKAMP, SUSANNE CRAIG, JEFFREY MCCRACKEN and JON HILSENRATH, Oct 6, 2008, “The Two Faces of Lehman’s Fall,”  Wall Street Journal.

[2] Neil Irwin, July 21 2009, “At NY Fed Blending in is part of the job,” Washington Post, indicates that Sept 18 is the date the New York Fed realized GS and MS were facing runs.  Federal Reserve Board, September 22, 2008 “Order approving formation of bank holding companies”
Gary B. Gorton, 2009, “Slapped in the face by the invisible hand” ( documents the withdrawal of credit from the repo market in the form of increasing haircuts – and discusses its similarity to a bank run.

[3] This may not represent the full extent of Federal Reserve lending to investment banks on October 1, 2008 as both Morgan Stanley and Goldman Sachs were now bank holding companies and could access liquidity facilities like the discount window and the Term Auction Facility.

10-6-09 update note: Corrected error regarding TSLF.

The Many Problems with Collateralized Interbank Lending #1-10

In addition to creating systemic risk and obfuscating financial reports, collateralized derivatives are not a good tool for hedging risk.  Let me be more specific:  derivative contracts can be perfect hedges as long as there is no risk that either counterparty will default.  Counterparty risk means that the derivative contract may be worthless and undermines its role as a hedge.  Collateralized derivatives are designed to address counterparty risk.  The problem with this “solution” is that collateralizing a derivative contract can undermine its use as a hedge, too.

First note that the standard analytic framework used to explain how derivatives serve to hedge risk assumes that both counterparties are money good.  In particular whenever a proponent of derivatives claims that they can be distinguished from other securities by the fact that they are “zero sum” and not subject to the losses that we see in asset markets, that individual is assuming that derivative contracts are not subject to counterparty risk.[1] It is true that, if one assumes away counterparty risk, derivative contracts can offset certain types of economic risk perfectly. An example is an airline that enters into a futures contract where the airline contracts to buy fuel three months in the future at today’s market price.  This airline has a perfect hedge against the risk that fuel prices will rise – as long as the airline’s counterparty honors his contractual obligations.[2]

One reason that the financial community developed the habit of assuming away counterparty risk when discussing derivatives is that, from the early years of the 20th century through approximately 1990, the vast majority of derivative contracts were exchange-traded.  When a derivative is traded on an exchange, the exchange is the counterparty to every transaction.  Because the exchanges put in place safeguards protecting them from losses, they are stable organizations and in the United States none has failed.  Thus, it is not unreasonable to make the assumption that there is no counterparty risk when discussing exchange-traded derivatives.

Over the counter derivatives differ from exchange traded derivatives because they are simply private contracts.  As a practical matter the only restriction on an over the counter derivative contract is that the two contract participants accept each other as counterparties.  Clearly counterparty risk can be a factor when dealing with over the counter derivatives.

In the event that a derivative counterparty defaults – and no collateral has been posted – the derivative contract no longer serves as a hedge.  Returning to our airline example, if fuel prices rise and the counterparty declares bankruptcy, the airline will be an unsecured creditor for the value of the contract at the date of bankruptcy.  The airline will be unhedged if fuel prices continue to rise after bankruptcy is declared and, like all creditors, the airline may receive partial or no recovery on its claim.  For this reason the credit risk of an uncollateralized over the counter derivative is more comparable to a financial asset such as a bond than to an exchange traded derivative – and uncollateralized over the counter derivatives are subject to losses due to default just like any other financial asset.

One way to mitigate the credit risk inherent in an over the counter derivative is to include a clause in the contract that requires the counterparty who owes money to post collateral.  This is comparable to the margin requirements used by exchanges, except that the terms of an over the counter contract are not standardized.  As late as 2003, the ISDA Margin Survey reported that only 30% of over the counter derivative contracts required that collateral be posted. Only three quarters of these collateralized contracts had terms that required both parties to post collateral.  Over time collateralized contracts have become the norm.  The 2009 survey reported that 65% of contracts included clauses requiring collateral.[3]

To understand how collateral works let’s use our airline example again and recall that the price fixed for the contract was the market price on the day the contract was signed.  If the price of fuel has fallen, so has the value of the airline’s contract – if the contract expired today the airline would lose money on it by paying a higher price for fuel than the market price.  In this case, the airline is “out of the money” and the airline’s counterparty is “in the money”.  (By contrast, if the price of fuel rises, the airline is “in the money” and the counterparty is “out of the money”.)  The purpose of collateral is to protect the “in the money” counterparty from the risk that the “out of the money” counterparty defaults on the derivative contract.

If the airline’s contract required collateral posting and the price of fuel fell steadily for the first month, then every day the airline would be required to post more collateral to cover the difference between the market price and the contracted price.  By contrast, when the price of fuel starts to rise, collateral will be returned to the airline.  And if the price of fuel exceeds the contracted price, the counterparty will post collateral to the airline.[4]

When there are no collateral requirements, the “in the money” counterparty to a futures contract faces credit risk.  When margin is posted, the “in the money” counterparty is protected from credit risk, and the “out of the money” counterparty must be prepared to post collateral well before actual payment on the contract is due.  Thus, a collateralized derivative contract protects against credit risk at the cost of creating liquidity risk (that is, the danger that liquid assets are not available to use as collateral) for the “out of the money” counterparty.  Futures exchanges have imposed margin requirements for over a century and, thus, have demonstrated that, despite the increase in liquidity risk, collateral is an effective way to protect the futures market from credit risk and guarantee its stability.

Over the counter derivatives, however, are sometimes very different from futures contracts.  Swaps in particular involve not just a single future payment, but repeated payments over an extended period of time.  Because the collateral posting requirements for a swap can involve summing over twenty or more separate payments, in some cases collateral becomes an onerous obligation.  The effect of a collateralized swap that by chance moves dramatically against one of the counterparties is similar to someone with a mortgage suddenly being called upon to have the full value of the house deposited at the bank.  Liquidity risk, when it involves large sums, can be a serious danger for derivatives investors.  This liquidity risk may undermine the swap’s effectiveness as a hedge.

To examine in more detail how collateral can undermine the use of a swap as a hedge, consider the example of a “plain vanilla” interest rate swap.  A university endowment has $10 million of debt on which it must pay the money market rate plus 3% for the next five years.  When the money market rate is 3%, the endowment will pay $50,000 per month and when the money market rate is 2% the endowment will pay $41,667 per month, and so on.[5] In order to protect itself from the possibility that interest rates rise, the endowment enters into an interest rate swap where it pays out a fixed rate of 6% per year (or $50,000 per month) and receives the money market rate plus 3% for five years.  Because the endowment receives from the swap exactly the amount that it needs to pay out on its debt, the swap is a perfect hedge for the endowment – if it is uncollateralized and the endowment’s counterparty does not default.

In the absence of a collateral agreement, the endowment has converted its adjustable rate debt into fixed rate debt – its liability is just $50,000 per month for five years.  If, however, the swap includes a collateral agreement and the money market rate falls and is expected to stay low for years, the endowment will be “out of the money”.  To illustrate what can happen to an “out of the money” swap counterparty, let’s look at the worst case scenario, where the money market rate falls to zero and is expected to stay there for five years:  in this example, the endowment pays $50,000 and receives $25,000 every month for five years.  Then the collateral the endowment can be asked to post is the present value of $25,000 a month for five years; when interest rates are close to zero, this approaches $1,500,000.  Thus, when a collateral regime is combined with a swap contract, it can have the effect of requiring a counterparty to have the means to prepay its obligations before they are due.

Because collateralized swap contracts involve large-scale liquidity risk, the only sense in which the endowment is hedged is on its balance sheet.  For the balance sheet the timing of the payments is irrelevant – all that matters is the total value of the firm’s claims and obligations.  On the balance sheet posting cash collateral is just a matter of moving the amount in question from cash assets to receivables.  Both of these items are assets so this change has a neutral effect on the financial report.

By any other standard, however, the endowment is not hedged.  In particular, there’s always the possibility that “cash assets” aren’t large enough to sustain the withdrawal of the cash needed for collateral.  In this situation, the endowment has a cash flow problem – just as a homeowner would have a cash flow problem if the mortgage lender had the right to demand that the full value of the mortgage be deposited at the bank.  “Liquidity risk” is a term that refers specifically to this problem.

The role of collateral is therefore to protect the “in the money” counterparty from credit risk at the cost of exposing the “out of the money” counterparty to liquidity risk.  For over the counter derivatives like swaps, it is far from clear that the gains from collateralizing the swap outweigh the costs.  Our example of an endowment was not entirely hypothetical.  Harvard University’s endowment faced precisely this situation – and, because cash flow was unavailable when needed, the University was forced to terminate the swaps, when their value was close to a nadir.  The University posted huge losses, but more importantly lost the hedge it had invested in over a period of years.  If the contract had not been collateralized, the University would have continued to make payments and in the event that interest rates rose again in the future, the University would have been protected.  Instead, the collateral terms of the derivative agreement were extremely risky – and cost the University its hedge.[6]

Interest rate swaps are not the only contracts that can require large amounts of collateral.  The terms of a credit default swap require the counterparty known as the protection buyer to make regular payments, and the other counterparty (called the protection seller) to make a much larger payment only if a specific firm defaults on its debt.  As the likelihood of a default by the underlying firm increases, the protection seller must post collateral.  Because the promised payment is large, the collateral requirement may also be large.  AIG is an example of a firm that failed due to collateral calls on credit default swaps – if the government had not taken over its obligations, it would have been forced to declare bankruptcy.

Not only do collateral requirements in some cases undermine the effectiveness of the contract as a hedge, but collateralized over the counter derivatives don’t necessarily provide effective protection against credit risk – despite safe harbor privileges.  The collateral necessary to cover the “out of the money” counterparty’s obligations changes every day with changes in the value of the asset or rate underlying the derivative.  In some cases these changes can be dramatic resulting in extremely large collateral calls.  Of course, it is precisely when price changes are dramatic that market turmoil and collateral calls are likely to cause the bankruptcy of a derivative counterparty.  Naturally, when a firm is bankrupted by collateral calls, then the firm’s counterparties will find that they are not holding enough collateral to cover the full amount due – and they will become unsecured claimants in bankruptcy court for the remainder.  In short, collateral requirements may not be an effective way to protect firms from losses due to market turmoil and sudden price movements.

Collateral requirements on credit default swaps are particularly difficult to manage.  In a credit default swap the protection seller owes nothing until a credit event occurs and, once the credit event occurs, the seller may owe tens of millions of dollars.  Thus, by their nature default swaps involve sudden changes in value.  Since protection buyers want to protect themselves from the credit risk inherent in such contracts, they use the cost of replacing the swap or the price of the referenced bond to estimate the likelihood that a credit event will occur.  Unfortunately, credit default swaps and the bonds they are written on often trade infrequently and may be difficult to price.  For example, when AIG faced collateral calls in late 2007, Joseph Cassano complained in a memo summarizing those calls:

[T]he prices we have received are all over the place and everyone we talk to has openly admitted that the bonds we are referencing have not, and do not, trade … As you can see where we do have more than one level they are never that close.  As a few examples, Goldman priced Dunhill at 75 and Merrill priced it at 95:  Independence V is subject to collateral call from both ML and GS, but the former calculates a price of 90 and the latter is using 67.5.[7]

As the AIG memo indicates, when there is no objective way to determine a fair price for a credit default swap, collateral calls are made without a clear foundation.  Thus, credit swaps have the particular problem that it is often difficult to determine how much collateral should be posted until a credit event actually takes place and full payment is due.

These two factors, that sudden price changes can render collateral inadequate and that for some derivatives it is very difficult to determine appropriate collateral requirements, mean that collateral may fail to protect the “in the money” counterparty from losses.  Thus, yet another problem with collateralized derivatives is that they can create the illusion of protecting a firm from credit risk without actually protecting the firm – particularly in a tumultuous market when protection is most needed.

Finally it is possible that, in the event of the failure of a large financial firm, the safe harbor provisions will actually serve to increase credit losses.  At the moment that a large firm declares bankruptcy many counterparties will simultaneously seize and sell collateral.  This process of exercising safe harbor privileges can generate the sudden sale of a large number of assets and have the effect of reducing the value of the collateral that was posted.  It may even be the case that these losses are just as large, if not larger, than the losses from having the collateral tied up in bankruptcy court for a few weeks.

In 1998 Long Term Capital Management, a hedge fund with a massive balance sheet, was heading towards bankruptcy and a fire sale of collateral loomed.  At the behest of the Federal Reserve Bank of New York, the major investment banks – who were also the hedge fund’s largest creditors – intervened, effectively taking over the hedge fund.  While a fire sale of assets was averted, the danger was acknowledged by everyone in the financial community.  In 1999 the ISDA published its first collateral review and found that cash collateral was “less commonly used”.[8] From that date forward the survey clearly documented increasing use of cash collateral in derivatives contracts.  In 2009 this trend culminated in cash accounting for 84% of all derivative collateral. [9] The reasoning behind this trend seems obvious:  cash collateral is the only form of margin that cannot lose value in the event that there is a fire sale.

Nowadays, it is repurchase agreement counterparties who worry that safe harbor provisions will result in a fire sale of collateral.  This is, in part, due to the nature of repos – they are always secured by a financial asset that can be sold – but also due to the fact that in 2005 safe harbor was granted to repos of less liquid securities like investment grade debt.  Of course, less liquid securities are far more likely to lose value dramatically in a fire sale, than, for example, government bonds.  For this reason repo markets that (i) trade in securities of limited liquidity and (ii) are granted safe harbor are inherently unstable.

[1] See for example the testimony of Richard R. Lindsay before the Senate Agriculture Committee on October 14, 2008. This is a commonly held view of derivatives.

[2] Of course, if fuel prices fall, the airline is locked into the higher price – this is the nature of a futures contract.  An airline that wishes to protect against a possible rise in prices without giving up the benefits of a fall in prices must pay an upfront fee for an option contract.

[3] ISDA Margin Survey, 2009,
ISDA Margin Survey 2003,
In 2009 one quarter of collateralized contracts only required one side to post collateral.

[4] For simplicity of exposition, I am assuming that the collateral agreement is bilateral and that both parties have a zero threshold for posting collateral.

[5] When the money market rate is 3%, (3% + 3%)/ 12 months = 0.5%.  Thus, each monthly payment is 0.5% of the principal or $50,000.  When the money market rate is 2%, (2% + 5%)/12 months = 0.4167%.

[6] Richard Bradley, 2009, “Drew Gilpin Faust and the Incredible Shrinking Harvard”, Boston Magazine.


[8] 1999 ISDA Collateral Review, p. 9

[9] 2009 ISDA Margin Survey.  While cash collateral has increased in recent years, even in 2003 70% of collateral was cash.

The Collateralized Lending Regime: An Under-reported Shift in Capital Structure #1-9

As noted above in addition to their effects on systemic risk, the safe harbor exemptions are unfair because they give preferential treatment in bankruptcy to derivative counterparties.  This problem is exacerbated by the fact that financial reporting has not yet adapted to a world with derivatives.  Safe harbor creates a class of asset that is exempt from bankruptcy – and thus senior to all other creditors.  However, because reporting is quarterly and does not include details about the potential for near-term collateral calls, unsecured lenders have no way of knowing what fraction of assets reported will be seized by counterparties at the moment of bankruptcy.  Without this knowledge, bond and shareholders have no way to evaluate the assets on which they have a claim.  Furthermore, one can no longer expect a firm’s financial statements to be comparable from one year to the next, because derivatives that simulate bonds and other assets have effects that are not reflected in financial statements.

Let’s think about an example of how derivatives can affect the meaning of financial statements.  A firm can sell preferred stock to an investor and at the same time enter into a total return swap with the investor.  The terms of the total return swap require the investor to pay the total return (i.e. any cash flows) on the preferred stock; in return the firm pays the investor the money market rate plus some spread and compensates the investor for any losses on the preferred stock (in case of bankruptcy).  The net effect of these two transactions ­is that the preferred shares are just a smokescreen to put on the balance sheet.  In fact the firm has used a self-referencing derivative to issue secured adjustable rate debt.[1]

In this example, the firm’s financial reports show an increase in equity.  The market value of the total return swap will be reported initially as zero (because the income from the investor perfectly offsets the cashflow to the investor) and later as a financial asset or liability depending in part on the movement of the money market rate.  The firm reports an increase in equity, when the economic reality is that the firm has increased its debt load.  Note also that secured debt generally pays a lower interest rate than preferred stock, so the firm reduces its cost of funding by using derivatives in this manner.

The problem of course with this example is that the true state of the firm’s balance sheet is invisible to existing shareholders and bondholders.  When they review the firm’s financial statements, they will see an increase in equity and the increase in secured financing will remain hidden.  Of course, the more a firm funds itself with secured debt, the lower the recovery that both shareholders and (unsecured) bondholders can expect to receive in the case of bankruptcy.

Derivatives, as they are currently reported on financial statements, can be used to obscure the true nature of a firm’s liabilities.  While self-referencing derivative transactions may under certain circumstances be fraudulent in the United States, a legal note dated March 2009 concludes that they can be used – with caution.[2] Furthermore, because over the counter derivative markets are unregulated and not subject to reporting requirements, there is no way of knowing to what degree this is a problem.  In other words, there is no way of evaluating the inaccuracy – or accuracy – of financial statements.

Even in the absence of self-referencing derivatives, heavy reliance on derivative contracts can obscure the recovery that is available to shareholders and bondholders.  While the accounting rules for netting derivative and collateral exposures are strict,[3] reporting only takes place on a quarterly basis and there is no requirement to estimate or report collateral calls to which the firm may be subject in the near future.  Because large financial firms have significant exposures to derivatives, it is likely that, as a firm’s financial condition deteriorates, the same contracts that are generating losses will also generate collateral calls.  Furthermore many derivative contracts use credit rating downgrades as a trigger for collateral calls; this, too, means that a firm in deteriorating financial condition is likely to experience a sudden change in collateralized lending.  Currently shareholders and bondholders do not have the information needed to estimate the level of collateralized lending at the time of bankruptcy.

The current crisis illustrates the problem of changes in the level of collateral posted.  The ISDA Margin Survey reports that collateral posted tripled from 2007 to 2009.  The average amount of collateral posted per respondent was $4 billion in 2007 and $18 billion in 2009.  Furthermore because most of the collateral posted is delivered by the largest firms, firms that reported executing more than 1000 collateral agreements posted on average $16 billion in 2007 and $53 billion in 2009.  In short, the amount of collateral posted against derivative contracts can change dramatically from one reporting period to the next.  For this reason investors should be given information about potential future collateral calls whenever a firm trades in derivatives.

This information shortage regarding future collateral calls may mean that losses to shareholders and bondholders in the current crisis will end up being much more severe than expected.  If the losses experienced through the current downturn do indeed turn out to be excessive, firms may find it difficult in the future to finance themselves using bonds and other forms of unsecured lending.  In short, preferential treatment in the bankruptcy code for derivatives may completely change the capital structure of firms.

[1] I thank “A Credit Trader” for this example.

[2] Linklaters LLP, New York, March 12 2009, “Synthetic debt repurchase transactions and other transactions utilizing self-referencing exposure”

[3] FASB Interpretation No. 39

Safe Harbor and the Channels of Systemic Risk #1-8

By protecting banks from credit risk the bankruptcy amendments have the perverse effect of undermining the standard means by which banks protect themselves from risk.  The two most important tools traditionally used by banks to protect themselves are (i) a strong capital base to protect the bank from bankruptcy in the event of unexpected losses and (ii) the careful management of credit risk.  The safe harbor exemptions increase systemic risk by encouraging banks to view themselves as protected in the event of default – this encourages them to greatly increase their exposure to counterparty credit risk and to believe that unexpected losses are unlikely so that they do not need much capital and can operate with a high degree of leverage.

When the repo amendment was passed, it was precisely because dealers were highly leveraged that a bankruptcy could cause a chain of failures and disrupt the market.  Thus it is possible to view development of the repo market in the early 80s critically:  the development of a wholly unregulated financial market had led to excessive leverage and the risk of financial instability.  The market was in need of being protected by regulation in the form of capital and liquidity requirements.  Imposing such requirements on the repo market would, however, have restrained its growth and further increased capital requirements for banks that were already struggling.  There is no evidence that this policy was ever considered.

Instead, the 1984 repo amendment exempted repurchase agreements on Treasuries, Agencies and certificates of deposit from standard bankruptcy procedures.  By guaranteeing that these repos could not be tied up in bankruptcy the law reduced the risks faced by dealers who worked with small liquidity and capital margins and thus encouraged them to operate on a highly leveraged basis.

After the 2005 bankruptcy law was passed granting all repurchase agreements safe harbor, the leverage created by repurchase agreements soared.  Charles Munger describes the situation in an interview:

Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the “repo” system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome. The investment banks, to protect themselves, controlled, to some extent, the use of credit by customers that were hedge funds. But the internal hedge funds, owned by the investment banks, were subject to no effective credit control at all.[1]

Effectively after 2005, all securities became liquid assets.  Gary Gorton reports that up through April 2007 most repurchase agreements were not subject to any haircut at all, that is, they were for the full market value of the underlying collateral.[2] A dealer who owned – or borrowed – an investment grade security could use it to raise 100% of its value.  In short, every dealer bank had access to unlimited leverage, not only when investing in safe assets like Treasuries, but even when investing in bonds that were just one step away from junk.  They had speculative margin accounts with no margin.  This was only possible after the passage of the 2005 Bankruptcy Act.

In many ways what happened to the dealer banks in 2008 repeated precisely what had happened to stock market investors in 1929.  Asset values fell at the same time that margin requirements rose.  As borrowing levels became constrained, liquidity dried up and forced asset sales set off a vicious cycle.[3] The IMF explains that this dynamic played an important role in the failures of both Bear Stearns and Lehman Brothers.[4]

The safe harbor amendments not only encouraged financial institutions to become dangerously leveraged, they also encouraged them to become dangerously exposed to each other.  After the 1984 repo amendment was passed, the primary dealers’ financing in the repo market grew from $133 billion in 1984 to $834 billion ten years later, clearly increasing the exposure of the largest dealers to the market.[5] These trends continued at least up through 2007.

It is astounding to note that in 1999 the President’s Working Group recognized the fact that expansions of safe harbor had a tendency to encourage the market to grow bigger, but chose to focus on the benefits of “liquidity” and to ignore the possibility that increasing the exposure of market participants to counterparties could adversely affect systemic risk.  They write:

The ability to net may also contribute to market liquidity by permitting more activity between counterparties within prudent credit limits.  This added liquidity can be important in minimizing market disruptions due to the failure of a market participant.[6]

In short, the President’s Working Group assumed that market participants would keep exposures to a prudent level once safe harbor was in place, even though they had not done so in the absence of safe harbor protection.  After all, if prudent levels of exposure had been the norm before the bankruptcy exemptions were enacted, then the robust early growth of the repo and swaps markets demonstrated that these contracts did not need special treatment in bankruptcy to flourish.  The fact that these markets needed protection after they had already grown large was evidence that banks were not keeping credit within prudent limits before the passage of the laws.

In retrospect it is easy to see that neither repurchase agreements, nor certain derivatives were kept within prudent credit limits.  Bear Stearns was a beneficiary of the growth of repo markets.  The company’s quarterly report ending February 28, 2008, just days before it failed, states that total assets were $399 billion – and that $303 billion had been pledged to Bear as collateral.  Of this amount, Bear had “repledged or otherwise used” $211 billion.  In short, half of Bear Stearns’ balance sheet was financed using repurchase agreements.  That this lending was far from prudent was made clear in the second week of March when Bear was at the very edge of bankruptcy and was saved only by a shot-gun marriage with J.P. Morgan Chase and the assumption by the Federal Reserve of $29 billion worth of asset risk.

AIG is another example of a firm that failed because its counterparties were willing to take on excessive credit risk.  In the case of AIG the problem was credit default swaps.  In September 2008, AIG found that it could not afford to post the collateral required by its derivative contracts.  This failure to honor its contracts would have driven it into bankruptcy, had the government not stepped into the breach.  Given the Bear Stearns and AIG examples one can only conclude that, when the bankruptcy exemptions increased market liquidity, that increase was not tempered by the prudence of the counterparties.

The failures of Bear Stearns and AIG may have been exacerbated by the fact that the bankruptcy exemptions encourage counterparties to demand overcollateralization of their positions.  As the President’s Working Group observed in reference to the Long Term Capital Management (LTCM) collapse:

If its collateral holdings did not reflect potential future exposure, then a firm selling collateral provided by LTCM in the event of a default would still have been exposed to the difference between the value of the collateral and the value of the closed-out financial contract at the time the collateral was sold.[7]

In fact one of the recommendations of the report on LTCM is that banks should consider requiring that “potential future exposure” be collateralized – or in other words that current positions be overcollateralized.[8]

To understand the problem of overcollateralization it is important to recognize how profoundly bankruptcy law is weakened by the safe harbor exemptions.  Standard bankruptcy procedure guarantees that a secured lender gets the lesser of the amount due on the loan or the value of the collateral plus an unsecured claim for the remainder of the loan.  If a loan is overcollateralized the bankruptcy trustee has the right to reclaim the excess amount for the benefit of the other creditors.[9] By contrast, safe harbor protections allow the lender to seize collateral – and it’s not obvious that the trustee is in a position to determine whether or not excess collateral was posted.  While this already undercuts the very principles of bankruptcy, the safe harbor privileges go further:  even if the transfer of collateral was fraudulent, as long as it was received in good faith, the other creditors in a bankruptcy action have no rights to it.[10]

In short the safe harbor laws are deliberately structured to encourage counterparties to demand that their positions be overcollateralized – especially when the danger is growing that a firm will in fact declare bankruptcy.  The legal protection of overcollateralized derivative positions creates two problems:  first, it interferes with the principles of fairness that bankruptcy laws are designed to protect and, second, it may have systemic implications.

Consider what happened in each case when Bear Stearns, Lehman Brothers and AIG were about to fail.  Repo counterparties refused to roll over the contracts or derivative counterparties sought additional collateral.  It is precisely because of the strong protections for collateral that counterparties are so aggressive in their demands.  According to lawyers interviewed by the Financial Times “under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.”[11] In the modern financial regime, the demands of counterparties ensure that as soon as bankruptcy is suspected, failure becomes a certainty: no counterparty wants to be the one that didn’t demand collateral or withdraw its repurchase agreements fast enough.  Without the extraordinary privileges granted by the safe harbor protections, counterparties would be much more reluctant to force a firm into bankruptcy.

[1] Stanford Lawyer, Spring 2009, p. 17

[2] Gary Gorton, Dec 31 2008, “Information Liquidity and the (Ongoing) Panic of 2007,” p. 10.

[3] Gorton, 2009, pp. 33 – 38 has a thorough description of this process in the 2008 repo market.  For the 1929 crisis see J.K. Galbraith’s The Great Crash.

[4] IMF, “Assessing risks to global financial stability,” Global Financial Stability Report, Oct 2008, p. 25.

[5] Data from Federal Reserve Bulletin.  Available at The number of dealers doubled from the 1960s to the late 80s and declined from the late 80s onward.

[6] PWG, p. 20.

[7] President’s Working Group on Fin. Mkts., Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999), p. 21.

[8] PWG, p. 34

[9] Kettering, p. 1599-1600.

[10] PWG p. E4.

[11] Francesco Guerrera, Nicole Bullock and Julie MacIntosh, Oct 30 2008, “Wall Street ‘made rod for own back’” Financial Times.