Deus Ex Macchiato

Matt Levine has an excellent dealbreaker post which in turn references a Bloomberg story on Lehman’s derivatives. The facts first:

Almost five years after Lehman Brothers filed for bankruptcy and set off the global financial crisis, managers of the bank’s estate are demanding millions of dollars from retirement homes, colleges and hospitals… [For instance] The Buck Institute for Research on Aging in Novato, California, gave Lehman $2 million in October 2008 to cancel a swap contract used to manage fluctuating interest rates. Lehman [now] says it wants $12.1 million more and has assessed at least an additional $4.7 million in interest, the research center said in its most recent financial statement.

There are at least two important issues here. First, as Levine points out, when you closed your swap out with Lehman matters hugely for valuation. (I have cropped the market data he gives to show the USD 5y swap rate in the period after the default: look at that volatility in late 2008.) The CSA you had with Lehman matters too, as does whether you use market valuation or actual close-out (which in turn depends on the details of your master agreement with them), what CSA you had with the party you closed out with, and so on. Moreover, the naive idea that your claim against Lehman is the price you closed out isn’t necessarily true. Levine quotes from the Federal Home Loan Bank of Cincinnati’s 10-K:

We had 87 derivative transactions (interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman Brothers Special Financing, Inc. (“LBSF”), with a total notional principal amount of $5.7 billion. Under the provisions of our master agreement, all of these swaps automatically terminated immediately prior to the bankruptcy filing by Lehman Brothers. The terminations required us to pay LBSF a net fee of $189 million, which represented the swaps’ total estimated market value at the close of business on Friday, September 12… … On Tuesday, September 16, we replaced these swaps with new swaps transacted with other counterparties. The new swaps had the same terms and conditions as the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee of $232 million to enter into these transactions based on the estimated market values at the time we replaced the swaps.

Now, that difference in value could have been a market risk gain based on a period of open exposure in very volatile markets. But it could also be partly a mismatch between the close-out amount the Home Loan Bank paid Lehman and the real market price. You can see how a lawyer might think that there is a case there, especially one paid to maximise the value of Lehman’s estate (for the benefit, let’s remember, of other creditors).

I am not sure how to react to this. The knee-jerk response is to demand that the close-out process is defined so as to lead to less disputable results, but doing that is not straightforward. What is applicable for the (unusual) Lehman-like events probably isn’t appropriate for much smaller (and more usual) close outs. Moreover, any claim on a bankrupt must, ultimately, be subject to scrutiny by the bankruptcy courts, and must adhere to underlying legal principles (like anti-deprivation). So the right policy here is not obvious. But certainly the risk of closing out then, years later, having that process challenged by the defaulter’s estate with the potential for large amounts of interest being assessed as well as the original claim, is material. Whether there is anything that can be done about it is less clear.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
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Those of you with multiple devices – and most of us these days have at least two out of a phone, a tablet, a laptop, a desktop and an ipod-like thing – will be familiar with the nightmare of sync. This is particularly painful with music: you have it nicely set up in one place, yet somehow it ends up as a mess after transfer. A particular culprit here is itunes, which (1) Apple forces you to use and (2) seems to me to be as respectful of my music labeling as a con man at an easy marks convention. As a result, (be warned, painful confession coming up) my ipad thinks I have music by Pink, P!nk and P!ink with a Kanji character on the end that I can’t even copy; it thinks my Brahms fourth symphony is by Karajan and that Stranglers and The Stranglers are different artists. It has UB 40 and UB40, it puts plainsong under ‘Unknown’, and it is very very fond of ‘Unknown Album, Unknown Artist’. This is rather irritating and it takes a while to fix.

Given the state of this relatively small data set, rather little of which was manually entered*, imagine how good banks legal entity identifiers are, given that they could from a much bigger database much of which has been typed in. There is, it is fair to say, the possibility of error. In particular, just like my multiple Pinks, there is some chance of finding The Goldman Sachs Group, Inc. and Goldman Sachs Group, Inc or even The Goldman Sachs Group, Inc in your counterparty database. (That period is easily missed.) And if one bank can’t always get it right, how much harder is it to sync this data across the whole industry? The legal entity identifier (‘LEI’) project tries to do that, and it is much to be applauded. In particular without initiatives like this, trade repository data is a lot less useful.

Deadlines for getting LEI data into shape are approaching. As Katten Muchin Rosenman remind us:

Every swap end user (i.e., any party to an outstanding derivative contract who is not a swap dealer or major swap participant) should be aware that April 10, 2013 is the deadline for obtaining a “CFTC Interim Compliant Identifier” number (or CICI) in connection with its swap activities. The requirement arises under Commodity Futures Trading Commission Rule 45.6(f), which specifies that every “swap counterparty” must use a legal entity identifier (LEI) in all recordkeeping.

Meanwhile the data cleaners are doing a rather more systematic job than me swearing at itunes. This is well underway at many banks but, for those laggards, Mark Davies has a point: “processes relating to business entity reference data will require attention sooner rather than later”.

*Most of my music is from CD, and most of those auto-load the album and track information when they are ripped. The databases that information comes from, mind you, are not perfect.

Posted in: Legal Risk and Trade Documentation, Software and Virtual Worlds by David /
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In a move that will at very least make life more interesting, Bloomberg has done as it threatened and sued the CFTC. Their bone of contention is the so-called margin period of risk on OTC derivatives vs. futures. As the FT reports:

Bloomberg objects to how the CFTC has set different margin rules, that favour swap futures at the expense of OTC swaps, arguing that they are similar financial products with the same risk profile for investors.

The CFTC has set minimum margin collateral that can cover five days of possible losses for cleared financial swaps, while margin for futures contracts traded on exchanges presently covers the risks of one to two days of losses.

In other words, swap futures are economically (very nearly) identical to swaps, but have roughly half the margin – and that, Bloomberg suggests, is wrong. The FT quotes their lawyer, Eugene Scalia, as saying “It’s a basic legal principle that similar matters should be treated in similar ways.” Watching the CFTC try to defend this one is going to be fascinating.

Posted in: Clearing and Collateral, Legal Risk and Trade Documentation by David /
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Yes, I know it’s a strident title. Bear with me, because I want to share some of James Stewart’s bile with you. Unlike the guy from It’s a Wonderful Life, this James Stewart has a nice line in barbs:

…an electoral system unworthy of Soviet-era sham democracies is flourishing today in corporate America is largely thanks to the management- and director-friendly policies of Delaware

Why? Well broadly because even if a majority of shareholders vote against a director of a Delaware corporation, they don’t have to resign, and even if they do resign, the company doesn’t have to accept their resignation. Mr. Stewart, then, has a point.

Posted in: Legal Risk and Trade Documentation by David /
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The overnight repo rate on the 2% T bond of February 2023 bond did some odd things in March, as Real Clear Markets reports:

[The repo rate] had been about 20 basis points in the week prior, but fell negative on Monday, March 11. By the close on Wednesday, March 13, the overnight repo rate was -2.95%. That day the Treasury sold $21 billion in a 10-year reopened auction that seems to have abated the negative repo after settlement… Such a negative repo rate indicated a sharp and acute shortage of collateral.

RCM suggests that the withdrawal of deposit insurance above $250K and QE caused a collateral squeeze. I don’t have a clear opinion on that, but I do know that negative repo rates that size are a cause for concern.

Posted in: Legal Risk and Trade Documentation, Markets by David /
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Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader

started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.

The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.

Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.

The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.

On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.

The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.

Posted in: Legal Risk and Trade Documentation, Liquidity and liquidity risk, Markets by David /
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The bankruptcy trustee’s report into MF Global is out, and Louis Freeh has done an interesting job. It comes close to saying that there is a case against Corzine, without actually stepping over the line. Here’s one of the punchlines:

The negligent conduct identified in this Report foreseeably contributed to MF Global’s collapse and the Debtors’ subsequent bankruptcyfilings. Although a difficult economic climate and other factors may have accelerated the Company’s failure, the risky business strategy engineered and executed by Corzine and other officers and their failure to improve the Company’s inadequate systems and procedures so that the Company could accommodate that business strategy contributed to the Company’s collapse during the last week of October 2011.

It will be interesting to see how this one plays out.

Posted in: Legal Risk and Trade Documentation by David /
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Many big banks have now had large operational risk-related events in the last few years, notably litigation related (think for instance of the PPI settlements in the UK or the mortgage ones in the US). What has that done to the banks’ operational risk capital models I wonder? You would have thought that having those large losses in the modeled distribution fattened out the tails no end…

Update Opdyke and Cavallo say:

…certain types of events are “industry” events that occur at multiple institutions in the same general time period, such as the wave of legal settlements related to allegations of mutual fund market timing. An institution that itself incurred one or more such losses may be justified in excluding other institutions’ losses (if they can be identified in the external data) since that specific industry event is already represented by an internal loss in the bank’s loss data base.

That is reasonable. What is less so is ignoring your own loss, taking the industry wide loss from some database and dividing it by the number of banks contributing towards the database. That has the effect of softening the loss considerably. Mind you, give what BofA for instance has paid out in mortgage related litigation, without that kind of approach its op risk capital requirement at 99.9% confidence under the AMA (were that to be the standard, which, right now, it isn’t in the US) would surely be more than the capital it has…

Posted in: Legal Risk and Trade Documentation, Operational Risk and Rogue Trader by David /
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Those guys. Wow. Soooo cute.

Occupy the SEC has filed a lawsuit in the Eastern District of New York against six federal agencies, over those agencies’ delay in promulgating a Final Rulemaking in connection with the “Volcker Rule”.

Posted in: Legal Risk and Trade Documentation, Regulation by David /
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Shearman and Stirling have a useful note on an important case in the UK:

The High Court in London has held that clients of insolvent UK brokers are entitled to a claim based on the value of their open positions as at the date of entry into administration or liquidation, rather than based on the value actually realised when those positions are closed.

Note that this is not the way things work in the bilateral world…

Posted in: Legal Risk and Trade Documentation by David /
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An interesting observation from Steven Davidoff, who has been reviewing what was actually in the Abacus documentation:

Sophisticated investors are supposed to read the documents. We all know that retail investors don’t often take the time to read disclosure, but the securities laws are based on the idea that information is filtered into the markets through disclosure to sophisticated investors who then set the real price of the security.

This is a form of the efficient market hypothesis. If sophisticated investors can’t be bothered to read the documents and act on them, then we have a real gap in the entire disclosure regime and asset pricing generally.

I do think there is ample evidence that ‘sophisticated’ (at least in terms of the amount of money they have and the time they have been investing) did not read the docs of the deals they entered into. But that isn’t a flaw, that is a feature. Caveat emptor — they didn’t, and they lost money. That, surely, is the way it is meant to be.

Posted in: Legal Risk and Trade Documentation, Markets by David /
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From the Wheatley review final report:

5.9 Therefore, the Review recommends that the number of currencies and tenors for which LIBOR is published be reduced. Specifically:

• publication of all LIBORs for Australian Dollars, Canadian Dollars, Danish Kroner, New Zealand Dollars and Swedish Kronor should be discontinued;
• for remaining currencies, publication of LIBOR for 4 months, 5 months, 7 months, 8 months, 10 months and 11 months tenors should be discontinued;
• continued publication of overnight, 1 week, 2 weeks, 2 months and 9 months should also be re-considered.

The maturity restrictions are probably not a big deal but the currency ones are. As IFR says, this could trigger years of lawsuits if the floating rate for trillions of dollars of swaps disappears.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
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I fought the Lawsky and the Lawsky won.

(HT Jonathan Weil, music video here.)

Posted in: Fun, Legal Risk and Trade Documentation by David /
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A friend of mine has just pointed out that for a social worker to renew their license in the US, they have to have had at least 4 hours of ethics training in the past two years. Perhaps given recent Abacus/Libor/muni swaps/corporate swaps/… it should be a criteria for renewing your series 7 or FSA registration too. Luigi Zingales argues on Bloomberg that we need to improve the ethics training in business schools, and I agree, but ethics is not a learn once and forget thing; constant reinforcement is needed, especially if you are dealing with a group that may well include psychopaths.

Posted in: Legal Risk and Trade Documentation, Organisational Culture by David /
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Is it just me, or does the shard remind you of old master pictures of the Tower of Babel too? I’m not so much thinking of the famous Breugel, more Doré or that odd one in the Kur- pfälzisches Mueseum.

If I were the CEO of any financial institution looking for a new home right now, I’d pick somewhere modest, ideally not in a capital city and certainly not in an iconic building like the Shard. Stamford, not New York; Marylebone not Canary Wharf or the Shard. It might look nice, and I am sure that the views are amazing, but a highly visible banker is a banker derided at the moment.

Posted in: Legal Risk and Trade Documentation, Photography by David /
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Ah, I see now, Barclays is indeed in more trouble than it first appeared. Not only is there the threat of lawsuits from all the parties whose Libor fixings were effected, but there is also evidence that they ignored prior warnings. From the FT:

Barclays’ compliance department failed to act on three separate internal warnings between 2007 and 2008 about conflicts of interest and “patently false” submissions by its staff to the panel that sets the benchmark interest rate used to price mortgages and credit card loans worldwide.

Perhaps, as in other cases, Diamonds are not forever.

Posted in: Legal Risk and Trade Documentation by David /
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Good questions from Dealbreaker, apropos the ongoing Libor issues:

If Libor isn’t just a trimmed average of some numbers that some banks tell someone from Reuters every day, then it is … the risk-free rate? The unsecured borrowing rate for AA banks? The unsecured borrowing rate for an actual assortment of disparately rated, often barely investment grade, rather tarnished banks that mostly don’t actually lend to each other?

Don’t worry, though, there are only a few hundred trillion dollars worth of contracts linked to Libor. Bob is handing back his bonus, and that is an act that one can applaud. But there are more serious issues here than an attempt to move the rate – like what happens to all those swaps that reference 3 or 6 month Libor in a world where there is little or no 3 or 6 month unsecured borrowing by banks.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
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Perhaps tediously, I want to go back to the size of JPMorgan’s surplus liquidity. Bloomberg has some new data:

About half of the $381.7 billion in JPMorgan’s chief investment office portfolio is in company bonds, asset-backed securities and mortgage debt not backed by the U.S. government, according to a March 31 filing. That compares with 7.7 percent at the end of 2007. The amount, $188.1 billion, is more than the holdings of such securities by its three biggest competitors combined. It exceeds the total assets of Atlanta-based SunTrust Banks Inc., the 10th-biggest U.S. lender.

There is an ideal size for an investment vehicle: $50M is too small; $500M is perhaps ideal; $10B is getting to be too large. This is because you want to be big enough that people will take you seriously, sign ISDAs with you and so on, but you want to be small enough that you are nimble and that your positions don’t move the market too much. Very large funds find it very hard to invest themselves anywhere near as profitably as smaller ones.

Now look at JPM’s CIO. They are a thousand times bigger than the ideal size. Simply finding a reasonably safe home for that $400B is quite difficult. Making a meaningful change to asset allocation is very difficult. This isn’t expiation for the losses – just another sign that JPM, along with its peers, is too big.

Posted in: Hedge Funds and Investment Management, Legal Risk and Trade Documentation, Writedown by David /
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My earlier post on the duty a company has to maximize profits to shareholders attracted quite a lot of comments (well, quite a lot for DEM anyway). Andy helpfully pointed me towards Dodge v. Ford Motor Company, and that in turn lead me to Lynn Stout’s paper on the case.

What we seem to have, in US law (and Delaware law in particular, given most large corporates in the US are incorporated in Delaware) is the following:

• There is no obligation for a US corporation to make money for shareholders provided that it says what it is going to do. Non-profits are often structured as corporations for instance.
• However, there is an obligation to treat all shareholders equitably. (This was one of the main issues in Dodge v. Ford.)
• Moreover absent a statement that a company isn’t there to make money for shareholders, there is a presumption that it is.
• However the business judgement presumption (that absent compelling evidence to the contrary, Directors are presumed to be acting in the interests of the corporation) is very strong in Delaware law, so shareholders often find it difficult to find a colorable claim on management for conduct that didn’t end up being in their best interests.

In other words, a Delaware corporation can act in the interests of a wider group than just shareholders, and it is unlikely that they can be sued for it. Exactly where the boundary of business judgement lies here, though, would have to be settled on a case-by-case basis.

Posted in: Legal Risk and Trade Documentation by David /
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Back in May last year, I wrote:

Greek CDS typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?

People are now waking up to this. FT alphaville for instance says today:

…Old R trades won’t have bucketed auctions even when the credit event in question is a restructuring.

So the question becomes whether anyone wrote CDS contracts with anything other than Old R trades on Greece. If there are MR or MMR trades there would have to be an auction with buckets.

Now, FT Alphaville didn’t think anyone had MR or MMR trades on Greece. Or, if they did, we thought it would be a booking error that would be cleared up.

But then, we saw this in a note from JP Morgan on February 24th (emphasis ours):

A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause “Old Restructuring” (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small.

Now, that’s weird.

That was the first we’d ever heard of Greece CDS trades with MR or MMR. And we’re still thinking that someone at some point made a mistake.

Not necessarily. Restructuring is just a convention. You can negotiate whatever you want. Maybe someone needs restructuring to get capital relief*. Maybe they are doing a basket and they want the same restructuring choice on all the names in the basket. Maybe they just ticked the wrong box. But once you have agreed to, say, MMR, changing it to Old R is going to cost something. Pretty soon we’ll see if it was worth paying or not…

Now it is nearly the weekend, and I don’t plan on spending it thinking about CDS, so let me leave you with one of the more interesting google hits on ‘Old R’. Can anyone tell me what a single Oerlikon is and how it might help me in a bond auction?

*That, BTW, is why US corporates trade on XR – the FED does require restructuring as a credit event to give capital relief, while European regulators do. For extra amusement, read the letter from the insurers to ISDA over Xerox. It is in appendix one of this document, the choice sentence being ‘The current definition of Restructuring is clearly not workable if it is susceptible to the misinterpretation, as it apparently is in the minds of certain market participants, that there has been a Credit Event with respect to Xerox.’

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Sovereign Default by David /
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I have been mean about Felix Salmon in the past, but this piece is really good.

The basic problem is this. If I have bought protection on 100 notional of a bond then I expect to be able to deliver whatever 100 notional of the bond turns into after the restructuring event, even if there is collective action and an exchange into new bonds. So if my 100 turns into 20 notional of new bonds which actually trade at 21 post exchange, I should be settled on the value of those 20 notional.

Felix points out that sovereign CDS documentation doesn’t track notionals, so I have to deliver 100 notional of new bonds, even if it was not a 1 for 1 swap. (Benton!)

Surely this is relatively easy to fix. All we need to say is that if 100 of old bonds turn into 20 notional of new bonds, an apple and two chocolate eclairs, I can deliver 20 new bonds, a pumpkin and two chocolate eclairs into the auction and get 100, or alternatively get cash settled on the current market value of 20 new bonds, a pumpkin and, yes, two chocolate eclairs. (For the avoidance of doubt, the chocolate eclairs are clearly the most valuable part of the package.)

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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In the mists of time, pretty much when dragons walked the earth, CDS referenced specific bonds.

What that meant was that if there was a credit event on that bond then you got to deliver that bond or were cash settled* on the value of that bond after the credit event. This meant that if you owned that bond and the CDS on it, you were hedged against the consequence of credit events (although obviously not against things that turned out not to be credit events**).

This was really good in that there was little basis risk between the CDS and the bond. But it was really bad in that it made CDS fairly illiquid. In this setting, a 1 year CDS on say the UK 4¾% Treasury Stock 2015 is not the same as one on the 4% Treasury Gilt 2016 despite the fact that both bonds are senior obligations of the UK government and both cross default. It would be really hard to imagine a credit event on the 4¾s of 2015 that wasn’t also a credit event on the 4s of 2016 – and vice versa – yet these two CDS are not in any way fungible. That reduces liquidity dramatically, and it means that dealers have to hedge each CDS with its underlying bond (or another CDS referencing the same bond). Well, either that or take basis risk anyway.

The market decided that it preferred some deliverability risk to illiquidity, so instead of trading CDS that referenced specific bonds, it began to trade CDS that referenced a specific obligator. You bought CDS on the UK (or more specifically on senior unsecured UK government obligations) rather than on a given bond. That single step dramatically increased liquidity, but it brought deliverability risk in cash settled CDS: you now no longer knew that the price the CDS settled at would reflect the value of the bond that you owned, as the settlement process was determined with respect to a basket of instruments.

Now all of this was long before the auction process was developed, and it was the key decision that meant that CDS were not as good a hedge as they used to be. The market chose to trade a product that hedged individual bonds less well in exchange for having a more liquid instrument. Now I am not going to take a position on whether that was a good choice or not, but I will say this. If you want a CDS that references a particular bond, and whose settlement amount is determined by the price of that bond after the credit event – or which allows you for sure to deliver a given bond – then buy one. Yes, it will cost you more than a standard CDS that is more liquid. It won’t have a readily observable price (although one might assume it would mostly trade in line with more liquid standard CDS). It will be hard to trade. But if you want a Ferrari, why are you buying a Ford?

*Of course, you want to be rather careful how a cash settlement amount on an illiquid bond is determined.

**Cf. restructuring. That is a different story, which also must be understood in any analysis of what CDS do and don’t do.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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The Libor probe is heating up. Bloomberg reports:

Global regulators have exposed flaws in banks’ internal controls that may have allowed traders to manipulate interest rates around the world, two people with knowledge of the probe said.

Investigators also have received e-mail evidence of potential collusion between firms setting the London interbank offered rate, said the people, who declined to be identified because they weren’t authorized to speak publicly.

Now I have no special knowledge of this situation, and I have no idea whether banks did indeed manipulate Libor. But I do think that the design of Libor is inherently flawed. When they are asked to submit the quotes that are averaged to produce Libor banks are asked

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

Note the hypothetical: ‘could you… were you to…’. In other words, Libor isn’t necessarily the average of rates at which banks did borrow, but rather of rates at which they estimated they could probably borrow. That’s a big difference, and it makes it much harder for a bank to be sure that the numbers it submits to the Libor panel are right. [The issue is that banks don't borrow for longer tenors unsecured very much at all, so something like ten month Libor - or even one year Libor - may well be the average of guesses rather than of actual market rates.]

Obviously here there is a tension between having a lot of rates some of which are less well defined and having a rate that is really market price based. Personally though I would have thought that building a multi-hundred-trillion dollar industry on prices that may be the average of guesses might create some issues, such as the risk of manipulation…

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Rules by David /
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Businessweek reminds us that the MF global situation has still not been resolved, money is still missing, and an exchange of lawsuits seems likely between the administrators of the UK and US arms of the firm:

MF Global Holding Ltd.’s clients may be the losers no matter who wins a $700 million dispute between bankruptcy administrators in London and New York that threatens the return of money locked in customer accounts.

The trustee of MF Global Inc., the New York brokerage unit, is seeking the return of money used as margin for American customers trading in Europe. It wants U.K. administrators KPMG LLP to tap into $1.2 billion it had set aside for customers with segregated accounts, which are supposed to be protected.

One set of clients or other will lose out: if the US prevails, there will be less in the client money pot for UK customers; while if the UK wins, U.S. customers will be treated as unsecured creditors. They will get less, and have to wait longer for it.

(Yes, that’s your liquidity. No, you aren’t getting it back any time soon.)

None of this is going to be resolved for months due to a ruling expected from the UK supreme court. Reuters reports:

KPMG’s plan will have to take into account an imminent British Supreme Court ruling brought by British clients of Lehman Brothers, who have been arguing they had segregated accounts at the U.S. bank when it collapsed in September 2008.

The British Supreme Court is set to rule, perhaps as early as March, on the clients’ claims that they had agreed with the bank before its collapse that their funds would be segregated, though the assets were later found not to have been segregated when the bank failed.

Given all this, it is hardly surprising that some lawmakers are restive. We welcome a new publication to DEM, the Billings Gazette, for this one:

Sen. Max Baucus, D-Mont., called for an investigation Wednesday into the regulators of investment houses… [By which he presumbaly means broker/dealers.]

“The fact that over $1 billion of customer money is missing is inexcusable and raises serious questions about the regulatory system that was supposed to protect these folks,” Baucus said. “If laws were broken, the people responsible need to be held accountable. If not, we need to know where the laws failed so we can make them stronger and better protect folks in the future.”

Never fear though. A trade association is riding to the rescue. Dealbook tells us

The Futures Industry Association, which represents both small futures brokerage firms and big banks that run futures businesses, announced Tuesday that it had created a committee to explore new safeguards for customer money.

That will be just fine then. After all,

The new committee, whose roster includes representatives from Goldman, Morgan Stanley and the CME Group

So you can really take comfort in that. Oh yes.

Posted in: Clearing and Collateral, Legal Risk and Trade Documentation by David /
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FT alphaville has a post on derivatives netting, which is mostly reasonable, although it links to a piece by (self-proclaimed?) expert Das, which isn’t.

To begin with, it is important to understand what a properly executed master agreement does. I think of it as glue: it binds up all the contracts between two parties, so that instead of many little contracts, there is one big complicated contract. As a result of this glueing, the parties owe each other whatever the net value of the big contract is. Thus we get two forms of netting: payment netting on everyday cash movements, reducing the number of cashflows between parties; and close out netting, which means that if one of the parties is in contractual default, then only a single net amount is payable.

In jurisdictions where this works (which is most of them – Russia and China being the most prominent examples where it may fail), this means that there is a single claim against the estate of a failed bank (or a single payment to it if the defaulter is in the money on the big contract).

Now, the really delicate thing is how this close out amount is determined. Unsurprisingly, a standard methodology is not imposed as part of the standard master agreement as this agreement has to deal with both bank-to-client relationships, where there are often a small number of derivatives which are easy to value, and bank-to-bank relationships, which may be much more complex. Of course, the vast majority of close-outs are of bank-to-client relationships – and you don’t hear anything about these proceeding without disputes (which they do, all the time).

A big bankruptcy like that of Lehman Brothers generates litigation on pretty much everything. The amounts of money at stake are large enough that it is worth sueing. So people do, on whatever can reasonably be disputed – and often on something things that can’t. Derivatives are part of this, but they are not especially problematic. Indeed, as Kimberly Summe points out, Lehman’s derivatives have received a lot of unnecessary and unwarranted stigma. The unpalateable truth is that it was real estate lending and bonds that broke Lehman, combined with liquidity risk, not swaps.

So far, we have noted that derivatives are not unusual in creating court cases, and that most close outs are simple and effective. But there is an issue that remains: how can it be that reasonable people differ on what the close out amount on a derivatives portfolio is? The answer is that while bankruptcy law usually has a simple idea of what you can claim, determining that amount is not straightforward. Thus for instance in UK law, broadly, if I suffer a loss of £10 because of your bankrupcty, I have a claim of £10 against the estate of the bankrupt. The obvious example is that I have lent the tenner to the bankrupt. But with a derivatives portfolio, what have I lost? Clearly it depends on how much it costs me to close out the risk. I can’t – especially if I want to look good in front of the judge – just use my own valuation: I have to actually go into the market and close out the risk, then add up the cost of doing that. And what I do has to be ‘commercially reasonable’. Thus for instance getting separate bids on the equity, credit and commodity derivatives sub-portfolios might well be commercially reasonable, but doing separate trades on every derivative rather than offering a portfolio of mostly offsetting instruments to the market probably isn’t. (This is a point which Das gets wrong and which lies at the heart of the Nomura vs. Lehman case.)

The problem at the heart of close out, then, is figuring out what value a bank has been deprived of when one of their derivatives counterparties fails. This is often simple, but for a large multi-asset portfolio, it can be both complicated and sufficiently uncertain that it is worth going to court about. The real story isn’t that there is a problem with netting: it is that the valuation of big portfolios of financial instruments is difficult, especially when you have to do it in a crisis.

Posted in: Derivatives, Hedging and Convexity, Fair Value, Legal Risk and Trade Documentation by David /
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A pot pourri today:

• IFR has an interesting article on the Seat Pagine credit event. My guess, having no particular private knowledge of the situation, is that the release of the hitherto private loan agreement between SEAT and the SPV may have been intended to satisfy the ‘public information’ requirement of the credit event definitions.
• FT alphaville has a nice summary from Lewis Alexander, Nomura’s chief US economist, on how Dodd Frank has reduced the powers US regulators have to intervene in financial institutions. The bottom line is that while the reforms (combined with Basel III and the SIFI requirements) do in some ways make US banks more robust, the FED/FDIC/OCC complex now has less ability to help individual firms.
• A provocative but perhaps amusing quote from Philip Pilkington: “Austrian economics provided a metaphysical-theological basis for what is today called ‘libertarianism’ – a popular, dogmatic political cult in the vein of Marxism-Leninism.”
• Bloomberg has a story about some damning testimony from CME chairman Terrence Duffy to the U.S. Senate about Corzine’s knowledge of (presumably illegal) transfers of funds from customer accounts. That’s not what interests me, though, juicy though it is. Rather I want to highlight how the story describes the CME chairman’s role:
  

  Duffy, whose company is MF Global’s regulator and principal exchange

  That’s right. The CME is both a shareholder owned for profit firm which makes money if its members trade more, and the regulator of those members. Gosh, isn’t it amazing something went wrong?

Update. In an exclusive (well, only shared with 594,861 youtube viewers), we have Duffy’s actual statement. Probably.

(I particularly like the line ‘my morals got me on my knees I’m begging please stop that rehypothecation’…)

Posted in: CDS and Negative Basis, Clearing and Collateral, Legal Risk and Trade Documentation, Regulation by David /
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Goodness me there are some fishy things being written about BofA moving their derivatives to the retail bank (which of course has FDIC insured deposits). Some of the things that are not true include ‘If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral’ and ‘The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties.’ (These actually consecutive sentences too – clearly Reuters does not bother to fact check blogs.)

What is true is that a retail bank often has rather better liquidity than a broker/dealer. This alone makes it safer, and hence (assuming that liquidity does not get spread around the rest of the group – something that should not happen too much) the retail bank is more attractive as a derivatives counterparty. Note though that these days everyone uses the same interdealer CSA (zero threshold, daily margin, cash only), so there is no collateral advantage to being in the retail bank; moreover being in a retail bank doesn’t suddenly make derivatives super senior; they are just good only fashioned pari passu with senior debt, the way they always were – and not FDIC-protected.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
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There is an encouraging new notice of proposed rule making from the SEC regarding conflicts of interest in securitisation. The proposed rule would prevent sponsors of such deals from betting against them. It would moreover prohibit them from structuring deals whose primary motivation was to allow others to go short. (See here for comment from the NYT and here for the text of the proposed rule.)

Specifically

… a securitization participant would be prohibited from profiting from the decline of an ABS it helped to create (assuming that the conflict would be important to a reasonable investor), even if that securitization participant did not intentionally cause, or increase the likelihood of, such decline.

This would cover deals like Abacus where the motivation of selling the securities was to allow 3rd parties to short the underlying.

On a first read (the text is 118 pages long), the proposed rule seems more or less reasonable. While actively prohibiting securitisation sponsors is a good start, there is a need for a much more substantial retention rule too. I would require both originator and distributor of any securitisation to take a 20% vertical slice in the deal. (Compare this with the 5% current requirement.) In a second level CDO of ABS, there would be two distributors; that of the original ABS and that of the CDO tranches: each of these would have to retain 20%. This goes much further than preventing conflicts of interest: it actively aligns interests between distributor of the deal and buyers of the ABS.

It makes sense to prohibiting deal sponsors or originators from shorting the deal. But what about third parties? Here I am less convinced. If I know that a third party (Paulson, say) has created the deal in order to short it, and I still buy it, isn’t that my problem? I wouldn’t make it illegal: I would just say that buyers need to know all the facts behind the deal including its motivation and the presence of any shorts. So disclosure should resolve the issues around third party shorts. Of course, reputationally, few originators would want to bring a deal to market where they had to disclose that the deal motivation was to facilitate a short, but that that is another matter entirely.

Posted in: Legal Risk and Trade Documentation, Reputational Risk, Securitisation and Tranching by David /
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With a title like that, you know this is going to be technical. So I am going to assume you know what CVA is. The key point in hedging the credit spread sensitivity of the CVA is to note that you can calculate the sensitivity of the CVA to a small (1 basis point say) move in credit spreads and buy CDS with equal an opposite sensitivity. That way if the credit spread moves, the P/L in the CVA is offset by that in the CDS (ignoring gamma effects anyway) and hence you are hedged.

Unfortunately, you are not hedged on a jump to default, at least with standard single name CDS. This is because a portfolio of derivatives are not deliverable into the CDS, so you can’t just hand over the thing that generated the CVA and get its par value. (This is true even if the portfolio of derivatives has close out value exactly equal to the CDS notional you have bought – the point isn’t what it is worth; it is that it is not deliverable.)

Now you might argue that ISDA receiveables are pari passu with senior debt and hence a cash settled CDS should be fine. There are several problems here. First, the cash settlement amount depends on an auction, and that has its own dynamics. The amount fixed here may turn out to be rather different from the eventual senior debt recovery. Second, events of default on derivatives are often wider than those on senior debt, so you may be able to close out the derivatives before there is a senior default. This again gives rise to a basis risk between the derivatives recovery and the CDS recovery. Finally, because of the deliverability issue discussed above, some (many?) supervisors do not give credit for CDS bought against CVA in the default part of the counterparty credit risk calculation. (The Basel 2 piece not the Basel 3 CVA charge.) This means that CVA hedging does not reduce regulatory capital right now. Messy, that, isn’t it?

Posted in: CDS and Negative Basis, Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
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I work with lawyers and accountants on pretty much a daily basis. Many of them are good people; many of them have impeccable professional standards. So I don’t entirely buy the line that Mark Everson plays in the New York Times that lawyers and accountants have lost their integrity. But I do think that there is something to his argument, so let me give you the gist:

Three or four decades ago, investors and regulators could rely on these professionals to provide a check on corporate risk-taking. But over time, attorneys and auditors came to see their practices not as independent firms that strengthen the integrity of capitalism, but as businesses measured chiefly by the earnings of their partners…

Obviously, to pay employees more and to increase partner pay to its present, staggering levels, billings needed to grow. Perhaps today’s approach to fee generation by leading law firms was best stated in a recent Wall Street Journal article about partners billing over $1,000 per hour. Said one such lawyer, “The underlying principle is if you can get it, get it.” Imagine a doctor saying that, for attribution, about an organ transplant.

Understandably, corporate clients are reluctant to pay through the nose for advice on how to color safely within the lines. Whereas concern for a company’s reputation on the part of its executives historically served to reinforce the conservative influence of the outside professionals, it is well documented that attitudes have shifted within corporations themselves. One need look no further than General Electric’s no-longer-obscure tax department to see how traditional law and accounting functions have morphed into profit centers.

Lawyers and accountants who were once the proud pillars of our financial system have become the happy architects of its circumvention.

Everson quotes a particularly well chosen example next:

Nowhere is this more the case than in the world of tax law. Companies (and wealthy individuals) pay handsomely for tax professionals not just to find the lines, but to push them ever outward. During my tenure at the Internal Revenue Service, the low point came when we discovered that a senior tax partner at KPMG (one of the Big Four, which by virtue of their prominence set standards for the others) had advocated — in writing — to leaders of the company’s tax practice that KPMG make a “business/strategic decision” to ignore a particular set of I.R.S. disclosure rules.

Certainly tax is one area where the spirit of the rules matters not a jot, and a lot of money is spent on trying to comply with the letter while not paying a dime more than necessary. That this is reputationally acceptable is a cause of sadness to me, but tears do not change policy. The IRS and other tax authorities can however fix the situation: they need to go nuclear on both the tax code which permits such manipulations and on optimization transactions like the infamous google double irish.

In the broad, though, the criticism is not completely fair. Audit partners are not typically for sale, Enron notwithstanding. If you want an honest opinion about an accounting standards issue, then you can get one from the larger firms. You can also buy advice about how it might be possible to structure things to get a desired accounting result, of course, and examples like Repo 105 do not do the industry credit here.

I am not sure that law firm conduct has changed that much. The term general counsel has the same root as Consigliere for a reason; a lawyer is there to help you do what you want to do legally, and to advise you not to do something stupid. A good lawyer is a reputational risk manager, amongst other things. But they are not there to outsource the CEO’s conscience, and I don’t think they have ever been. Advisors advise: it is the big guy who decides whether to take that advice or not, and hence bears responsibility for the decision. If professional integrity has declined, blame the CEO.

Posted in: Accounting, Legal Risk and Trade Documentation, Reputational Risk by David /
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