How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)

The effects of the derivatives safe harbors in bankruptcy that protect financially sophisticated creditors at the expense of the bankrupt company’s other creditors (and were greatly expanded by the no-derivative-left-behind act of 2005 — a.k.a. BAPCPA) are demonstrated by this Lehman Brothers lawsuit.

The former purpose of the bankruptcy process was to guarantee that all creditors receive no more than they are due under the law given that the bankrupt debtor is unable to meet all of its obligations.  The modern bankruptcy process allows derivative and repo counterparties to foreclose on any collateral posted to them. While theoretically they must demonstrate that the collateral they have taken was no more than was owed to them, the imprecision inherent in the process of marking complex assets to market clearly gives these counterparties the upper hand. In the event that discussion fails to result in the return of improperly seized collateral, the bankrupt debtor must sue the counterparty to get what is due the other creditors, as the Lehman lawsuit aptly illustrates.

It is a trivial matter to show using economic analysis that the costs to the bankrupt debtor of suing will guarantee that the vast majority of derivative and repo counterparties will be able to keep more collateral than they are due (unless they were undercollateralized at the date of default). In short the bankruptcy process now favors financially sophisticated creditors over trade creditors and debt-holders, not only because the financially sophisticated are able to negotiate more favorable contracts before bankruptcy, but also because they are able to take more than they are due under the law once a company enters bankruptcy.

Update 5-8-13: Matt Levine has done the yeoman’s job of reading some Lehman-related legal complaints and appears to reach similar conclusions.

Update 5-15-13: This article leaves the impression that that best targets for a lawsuit regarding the closing of a derivative contract are those who can’t afford expensive legal advice.

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The role of derivatives in the 2008 crisis

“More generally, the 2008 credit crunch was never related to worries over traded derivatives; it was — like all credit crunches — related to much more general worries over bank solvency and the quality of banks’ balance sheets.”  Felix Salmon

The claim that the 2008 crises were not related to worries over traded derivatives is simply wrong.  And I write this post to present some of the considerable evidence against this claim.  (That said, I agree with Felix Salmon’s critique of this article that the Greek default is not a good example of CDS-generated systemic risk.)

First, William Dudley the President of the New York Federal Reserve Bank has stated publicly that:  “The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.”

Novation takes place when, for example, a hedge fund decides that it doesn’t want to face Bear Stearns as a counterparty and therefore transfers the contract from Bear Stearns in order to face JP Morgan Chase.  In the process any collateral the hedge fund has posted to Bear Stearns must be transferred to JP Morgan Chase.

Second, the OCC derivatives reports (that include derivatives held by regulated commercial banks, but not by the investment banks) indicate that credit derivatives experienced much greater changes in values than other derivatives over the course of 2008.  Specifically credit derivatives comprised 20% of the fair value (summing positive fair value with negative fair value) of derivative portfolios in the first quarter of 2008.  (See Table 6 here.)    And by the third quarter had jumped to 32% of the fair value.  (here)  Thus, it reasonable to conclude that a minimum of 20% to 30% of the novations that played an important role in the collapse of both Bear and Lehman were due to credit derivatives.

It is entirely possible that significantly more of these novations were due to credit derivatives.  Since the aggregate fair value of bank derivative portfolios actually fell from Q1 to Q3 2008 by 6% or $250 billion, the increase in fair value of credit derivatives reflected a move from approximately $1 trillion to $1.3 trillion.  In other words, as one might predict, the value of credit derivatives moved much more dramatically during the “credit crunch” than the value of other derivatives.  Under the circumstances of these dramatic price changes, it seems safe to assume OTC derivative related collateral calls between Q1 and Q3 2008 were more likely to involve credit derivatives than other derivatives.  And I would posit that such collateral calls can trigger demands for novation.  Attibuting 30% of the novations in the credit crises of 2008 to credit derivatives is therefore probably a low estimate.

[Update 3-2-10:  The ISDA Margin Survey 2009, Table 4.2, indicates that from 2007 through 2009 66% of credit derivative exposures were collateralized.  Thus when the fair value of credit derivatives held by regulated banks increased by $300 billion from March 31, 2008 to September 30, 2008, it’s fair to assume that this had the direct result of increasing the demand for collateral over this period by $200 billion.  And this number excludes the increased demand in collateral created by the investment banks’ credit derivatives portfolios.]

Finally, we have the fact that New York Fed jumped on the CDS market after the Bear Stearns bailout – and didn’t allow Lehman to fail until after “centralized settlement among major dealers” for credit derivatives was implemented.  Previous industry commitments with respect to credit derivatives were focused on back office infrastructure issues and had a leisurely timeframe.  (This September 2006 press release indicates that significant advances for the industry included an end to novation without consent, an 80% reduction in the number of confirmations outstanding for more than 30 days, and a significant increase in the confirmation of trades on an electronic platform.)

In March 2008, by contrast, the industry agreed to automated novations processing by the end of 2008, and full implementation of centralized settlement among major dealers by September 2008.  The latter commitment was confirmed by the dealers in July 2008.  (page 3 here.)  In other words, the regulators moved from jawboning to a demand for commitments from the credit derivatives dealers for major changes in the clearing process that included very close deadlines, due to concerns over “the resiliency of the OTC derivatives market.”

While Felix Salmon may argue that this sudden seriousness about reform of the credit derivatives market was pure coincidence, most would conclude that it reflected regulators’ concern about the market after the failure of Bear Stearns in March 2008.

Overall, the claim that “2008 credit crunch was never related to worries over traded derivatives” is contradicted by the facts.  Insiders have acknowledged that novation of OTC derivatives played an important role in the crisis.  And I think Felix Salmon would have difficulty finding a member of the industry who is willing to assure him that the credit derivatives market would have handled the failure of Lehman effectively, if it had still been working with the market infrastructure of March 2008. Given this situation, the evidence points pretty clearly to likelihood fact that the CDS market was one of the reasons the Federal Reserve was unwilling to let Bear Stearns fail the way it let Lehman fail.

An additional note.  Felix Salmon writes, comparing bilateral clearing to a clearinghouse:

“If a bank has written so much credit protection that it becomes insolvent, then there’s significant systemic counterparty risk regardless of how its derivatives trades are cleared.”

Huh? The whole point is that the bank default to the clearinghouse is born jointly by the banks that guarantee the clearinghouse, instead of being born by individual counterparties – who are naturally more likely to be bankrupted by the bank’s failure to pay, then if they share the losses and thus divide them by 3 or 5 or some such number.

The point of a clearinghouse is not to prevent bad banks from facing a credit-crunch.  Obviously from an efficient markets point of view the sooner that happens, the better.  The point is that clearinghouse should help prevent the credit crunch/failure of a bad bank from taking down other banks that could potentially be made insolvent by excessive exposure to the bad bank — and thus to prevent the bad bank from setting off the chain of failures that defines a systemic crisis.  Of course, if the banks are willing to rely on collateral and choose not to limit credit to bad banks, then we’re in big trouble in either system.

The End of Equity?

Barry Ritholtz is blaming the falling value of bank stocks on the decision not to require mark-to-market accounting.  I’m wondering whether the fall isn’t a delayed reaction to the implementation of broad safe harbors for derivatives in the bankruptcy code (which was completed in 2005).

After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar.  What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008?  You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.

Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?

Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s.  Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?

Unintended consequences, indeed.

Update 10-8-11:  In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information.  So the underlying problem is that equity investors are asked to invest blindly.  While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.

Price movements are the point of “real-time transparency”

Pers Sjoberg and Susan Hinko of TriOptima argued in Financial Times this week that OTC derivative markets aren’t liquid enough to be subject to real-time transparency requirements.  But what does liquidity have to do with the social benefits of price transparency?

The correct comparison is not futures or option markets, but other illiquid markets like the corporate bond market.  And it’s far from clear that real-time transparency has been detrimental to the corporate bond market — in fact, the most recent news has been that the corporate bond market is thriving.

The authors argue:

[In] highly-liquid, standardised markets, real-time reporting and price transparency are meaningful concepts. When these concepts are applied to the OTC markets, adjustments should be made, especially given the fact that many of these low-frequency transactions have large notionals and need to be hedged discreetly to minimise hedging costs.

 

The whole goal of price transparency is that it should be impossible for anybody to “hedge discreetly.”  That’s the point.  Every transaction shows up in the market price.  If I do a bond transaction sequentially for two different accounts, I’m likely to see a price movement from one transaction to the next — and I trade in very small quantities.  But this is simply the inherent nature of trading on a functional market where my earlier purchase (which was completely unpredictable before I sent it in) shows up as having a price effect after it has been made public.  Price movements, like this, are the very purpose of transparent markets.

The authors continue:

However it is important for the new rules to reflect the realities of the market so regulators and the public have access to meaningful information. Intra-day reporting will place systems and cost burdens on institutions already restructuring to meet the demands of new legislation and regulation, and will not yield significant results to the public.

I don’t understand why purchases like my first purchase of an illiquid bond are classified by the authors as not “meaningful information.”  That’s a decision that the dealers on the market make when they post their bids and offers.  If a transaction is not meaningful to them, it will not shift the price, and, if it is meaningful to them, it will.

We can all understand that it is more beneficial to financial institutions for them to be able to trade with more information than the rest of us, but  it is far from clear that protecting their intra-day information is in the public’s interests.  If the only costs are structural, because financial institutions will have to set up real-time reporting systems, it seems to me to be in the public’s interest to create a standard that says that such systems should be set up for just about everything that financial institutions trade.  Thus, when regulators want real-time reporting of a new product, it should take the financial institutions days, not weeks, months or years to provide.

We live in a society where every pack of gum is bar-coded and consumers can do cross-store price checks on their phones.  Why has the financial industry chosen to maintain back office procedures that are practically medieval — even as they trade in multi-million dollar products?

If economists ruled the financial world

The negative reaction by many in the financial industry to this New York Times article critiquing the structure of over the counter derivative markets motivates me to make a very simple point:  Economic theory makes it clear that there is no reason to believe that trading activity will be socially beneficial when the market structure is as described in the article.

Elementary economics tell us that in order for the invisible hand of the market to work, pricing (including bids and offers) must be transparent.  That is, economics is explicit that it is only where there is public information about prices that self-interested behavior is socially beneficial or that the ability to make money on the market is an indicator that a valuable service is being provided to the economy.  [Ask any economist to explain a competitive equilibrium to you and you will find that good price information is a necessary condition for “first-best” social welfare to be achieved.]

Because transparent pricing is a pre-requisite to market trade having positive implications for society as a whole, if economists ruled the financial world these would be the foundational principles of the marketplace:

1.   [Enforceability of pricing regulations]  In general contracts that are not traded on SEC or CFTC regulated trading forums are unenforceable.  (Note that this is a revitalization of the reforms enacted during the Depression by the passage of the Securities Exchange Act and the Commodities Exchange Act.  Note also that I recognize the need for limited exceptions to this rule.)

2.  [Price transparency pre-trade]  Best bid and offer prices posted by market makers and other traders on all trading forums are publicly available in real time.  Market depth information is also publicly available in real time.  The cost of providing this data to the public is covered by a fee proportional to trade on the market (e.g. a penny per $100 traded).

3.  [Price transparency post-trade]  All completed trade data (item, time, price and quantity) on all trading forums is publicly available.

4.  [Meaningful prices]  All bids and offers have a minimum duration of one minute.

Moral Hazard and the Foreclosure Crisis

An important fact has been omitted from the ongoing discussion of the widespread failure to follow legal procedure not only in foreclosures, but also in forming and managing mortgage backed securities:  This is just another example of the consequences of moral hazard that is deeply engrained in the way our financial markets work.  The financial industry functions on the assumption that contracts and activities that are either illegal or unenforceable under current law will – as long as they involve significant bank losses or liabilities – always be made legal retroactively.

Over the past half century the financial industry has not treated the law as a bedrock institution that constrains the nature of its activities, but rather as a set of rules that can be forced to adapt to the industry’s needs and desires.  Thus, the industry knowingly and deliberately creates standardized contracts that are either designed to circumvent the law or in some cases flatly illegal under current interpretations of the law, and then when a case involving the contract arises (which in many instances happens only long after the standardized contract has become an institution), the financial industry tells the court that the dubious or illegal contract is so widespread that the court would create systemic risk by enforcing the law.  (This idea was established by Kenneth Kettering in “Securitization and its Discontents” and the next two paragraphs draw very heavily from Kettering’s article and perhaps form little more than an opinionated summary of several of his sections.)

Standby letters of credit are a clear example of this phenomenon.  In the 1950s banks started issuing “standby” letters of credit, which unlike traditional letters of credit (which were a form of secured loan) are nothing more than guarantees of the debt of bank clients.  As banking law in the United States has prohibited banks from issuing rendered bank guarantees of client debt unenforceable since at least the early years of the 20th century, the “standby” letter of credit was just an effort to repackage a product that was clearly unenforceable by making use of the name of a bank product of long-standing.  This effort was successful.  By the time that a bank failure led the FDIC to challenge the validity of the standby letter of credit in 1973, the market was so big that the FDIC was not willing to put forth its strongest argument – that as a guarantee, the product was unenforceable – because of the consequences of annulling such a large quantity of bank liabilities.  The consequence of this timidity was to grant the standby letter of credit the same standing in an FDIC resolution as a bank deposit.

Repurchase agreements are another example.  The UCC since 1972 has stated that its provisions on secured transactions apply “to any transaction (regardless of its form) which is intended to create a security interest …”  To argue that repurchase agreements did not fall under UCC §9-102 (now §9-109) because they took the form of a sale and repurchase is to engage in sophistry with the clear purpose of subverting the intent of the law.  And yet in the early 1980s – after the market for repurchase agreements had grown to exceed 5% of US GDP – this is precisely the argument that banks were making to judges in an effort to keep repurchase agreements out of bankruptcy court.  Because there were in fact judges who viewed it as their duty to protect the rule of law from the sophistry of the financiers despite – possibly genuine – claims of systemic risk, the industry did an end-run around the Bankruptcy Code by convincing Congress in 1984 to exempt from the Code those categories of repurchase agreements that were actually traded.

The whole over the counter derivatives market also falls into this category.  In 1936 the Commodities Exchange Act (CEA) codified the common law rules (pp. 722 – 23 in link) that had developed over the previous century by making contracts for future delivery (i.e. derivatives and forwards) legal if either (i) they were traded on an exchange or (ii) the intent of the parties was to settle the contract by transferring the underlying asset.  In 1974 the CEA was amended to explicitly include financial contracts under the provisions above and creating the CFTC as an agency enforcing the CEA.  In short, under the CEA the whole over the counter derivatives market as it developed through the 80s and early 90s was plainly illegal – until in 1993 Congress amended  the CEA to allow the CFTC to exempt certain contracts from the law.  (The CFTC under Wendy Gramm promptly exempted swaps and the controversy over Brooksley Born’s stymied attempts to oversee the over-the-counter derivatives market revolved around the wisdom of this exemption — see especially the comments in this link.  In the second comment, note the securities lawyer’s observation that there was not a single law firm in New York at the time willing to support Rubin/Treasury’s so-called claim that the CFTC did not have jurisdiction over swaps.  The Rubin/Treasury view is here and a more objective view here.)

We have a financial industry that views as normal the practice of deliberately creating systemic risk by developing financial instruments that will cause our largest banks to collapse, if the law in its current form is in fact enforced.  The end result of this process is that we have a legal system that – at least when it comes to financial transactions – is composed of laws written by and for the benefit of financial institutions themselves.

While I have a lot of sympathy for Paul Jackson’s point that these procedural matters don’t really matter to those who have defaulted on their mortgages, because in the vast majority of cases their default means they don’t have much of a legal claim to the house, the complete failure by a financial industry full to the gills with well-paid lawyers and real estate experts to comply with the laws governing mortgages and the transfer of real property is a big issue.  (And I see that Paul Jackson agrees with me on that last point.)  It is a big issue precisely because it demonstrates in very plain terms the financial industry’s utter contempt for the rule of law and for the tax-paying public that is counted on to open its wallet every time a bank sneezes.

Good speculation vs bad speculation

Betsey Jensen, a family farm owner and instructor in farm management, has an opinion piece in the NYT today defending speculation:

My biggest worry is what the legislation will do to speculators in the market. These are the traders who buy and sell wheat or corn without taking physical control of the crops. Farmers love speculators when they are buyers, helping push prices higher, and we despise them when they are sellers, driving prices down. Regardless of their position in the market, I am well aware that the system would not function without them — there wouldn’t be enough liquidity, or money, in the market.

According to the trading commission, about one-third of the long positions in hard red spring wheat futures, which is what I trade on the Minneapolis Grain Exchange, are owned by speculators. If speculators were driven out of the market, it would be as if I’d lost a third of my customers.

Will speculators continue to provide market liquidity if the legislation ends up increasing margin requirements — the amount of cash an investor must deposit before buying futures — or restricting how much or how often they can trade? Changes like these could do a lot of damage to agricultural markets.

Contrast this traditional Chicago (referring as much to the pits as to the University) view of speculation with the current corporate view of the state of modern financial speculation.  The FT reports that a survey of “European companies that depend on raw materials markets” finds:

But the companies surveyed ranked financial hedging as the least effective way of managing volatile raw materials costs, believing instead that inventory management and flexible pricing systems were more valuable tools.

In other words even as small American farmers are defending speculation in financial markets in the New York Times, many of the biggest corporations trading commodities are giving up on the pricing provided by those markets.

I’m repeating myself, but here goes:

Speculation is good when the speculator trades with someone in the real economy and therefore bears real economic risk.  Speculation is bad when the market is dominated by speculators trading with each other and, as they become a tiny fraction of the contracts traded, contracts bearing real economic risk stop determining prices.  Futures markets are successful only if the amount and nature of speculation is careful monitored to ensure that “enterprise [does not become] the bubble on a whirlpool of speculation” and “the capital development of the country [does not become] a by-product of the activities of a casino.”