Category / Legal Risk and Trade Documentation

Manipulating Codere December 7, 2013 at 12:33 pm

Matt Levine reports:

Blackstone Group LP bought credit-default swaps on troubled Spanish gaming company Codere SA, then agreed to roll a $100 million revolver for Codere on favorable terms in exchange for Codere agreeing to make an interest payment on some bonds two days late, thus creating a technical default and triggering the CDS, pocketing some gains for Blackstone at the expense of the CDS writers, without costing Codere anything

Now I am perfectly prepared to believe that this might not be market manipulation and that nothing actionable happened here. But if it wasn’t, why not? I mean, is this really ethically different from banging the close?

Identifying a fraudulent conveyance June 11, 2013 at 7:43 am

Carolyn Sissoko left me a highly thought provoking comment recently. She referenced a paper by Kenneth Kettering, Securitization and Its Discontents, that is definitely worth reading. Both Carolyn and Ken’s arguments are multi-faceted, and today I want to concentrate on one of them – the problem of identifying a fraudulent conveyance.

First, why do we care? Roughly, because if a transaction is judged to be one, it can be invalidated in bankruptcy. The buyer can be deprived of something that they might have thought that they had title to.

The foundation of the law here is ancient: a statute from Elizabeth I’s reign (13 Elizabeth 1571) according to Kettering. The idea, though, is simple: a transaction will be judged fraudulent if it was made with actual intent to hinder, delay or defraud any creditor. Thus for instance if on my bankruptcy some of my assets are transferred to you with consideration less than their fair value, then the conveyance is fraudulent and unlikely to be upheld by the bankruptcy judge.

There are many other issues in this space, and the issue is complex, so I am going to simplify down to just this one aspect of fraudulent conveyance and its impact on securitisation, because that is more than enough for one post.

Note that in order for there to be a fraudulent conveyance, there needs to be a conveyance; so any structure where the asset is not sold is not at risk (although obviously any other form of risk transfer might be). Thus for instance covered bonds are not a problem as (typically) the assets stay on balance sheet, and explicit statutory protection gives the bond holder security*.

The problem in cash securitisation is that consideration is often in several parts: I sell assets but keep junior tranches of the deal. Therefore if the assets turn out well, I am paid via excess return on the collateral pool going to the equity tranches. This often means that I can be unconcerned about a little over-collateralisation as, economically, it will come right in the end. Getting to the end though involves not going bankrupt, and that o/c meanwhile sails close to that badge of the fraudulent conveyance, selling something for less than it is worth†.

Now, I don’t take the position that securitisation ‘doesn’t work’ for these reasons: clearly in some operational sense it does work. But these considerations show that the interaction of ancient law and modern finance can generate friction and – occasionally – unexpected case law. (LTV Steel, a case that shook the entire securitisation industry, is a good example.) The risks are often greatest when one is pushing the edge of established structures and, perhaps unwittingly, crossing a line drawn hundreds of years ago and never re-drawn.

*Although see here for the rather less satisfactory situation in the US.

†The rules of article 9 of the UFCA are some help here, as they remove some of the risk of o/c.

The law and the window* May 27, 2013 at 1:10 pm

Laws are only imperfectly aligned with public morality. We (nearly) all agree, for instance, that theft is wrong, but a substantial number of people don’t see speeding as immoral. Moreover, even when something is legal, it isn’t necessarily moral. Indeed, as Louise Weinberg points out, there is in US law “a rather large legacy of judicial opinions struggling with immoral law—the old cases on slavery”.

Eventually, if the gap is big enough, the law is changed. Slavery was abolished, after all. This process is neither certain nor swift, but it is a foolish corporation who gets on the wrong side of it. Behaving legally does not necessarily protect against reputational damage, as Barclays has found out†. What you don’t want to do, then, is wait until the day before the law changes to get your house in order.

It’s therefore odd to hear that Google’s Eric Schmidt

has continued to defend his company’s tax position, saying if Britain wanted to collect more tax, it should change the law. In a phrase less snappy than the more celebrated “don’t be evil”, Schmidt said Google had “a fiduciary responsibility to our shareholders”

Yes, he does have a responsibility; but that extends to not destroying the company’s reputation too. Now obvious there is a calculation here – will outrage about tax structuring go away? My guess is that it won’t, and that companies that behave legally but in a way that comes to be generally seen to be unethical, will suffer. We can’t yet predict if current events represent a paradigm change in public morality, of course; nor can we say how Google or Apple or any of the others will be seen in future. But Schmidt and his peers have a duty to at least ask themselves the question. As Jonathan Weil says (apropos Apple), tax structuring may soon be seen as indicative of a more general lack of trustworthiness. That is something that no manager should accept lightly for investor trust, once lost, is not easily regained. You quickly become the unpleasant and unacceptable face of capitalism. Companies like Google and Apple, which desperately need to be seen as hip, should think very hard before they risk carrying that label.

*That’s the Overton window.

†Repeatedly: you’d think after the apartheid scandals they would treat more carefully, but no, there was Libor, and tax structuring, and mis-selling and… They weren’t the only ones, of course.

Lehman, five years later May 17, 2013 at 9:06 am

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.

5y USD swap rate after Lehman

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.

My ipad, and your derivatives April 22, 2013 at 5:55 pm

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.

Thank you Bloomberg April 17, 2013 at 6:13 pm

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.

Delaware and the sham of shareholder ownership April 16, 2013 at 4:09 pm

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.

The curious case of the 2s of 2023 April 12, 2013 at 8:05 pm

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.

Downing Drysdale April 9, 2013 at 12:18 am

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.

Freeh as a bird? April 5, 2013 at 12:26 am

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.

Fattening up the tails March 20, 2013 at 7:47 am

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…

Loving occupy the SEC February 28, 2013 at 10:26 pm

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”.

Don’t look back February 19, 2013 at 11:24 am

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…

Investors won’t read the fine print November 5, 2012 at 7:24 am

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.

So about those Ozzie swaps September 28, 2012 at 8:43 am

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.

The Clash on Standard Chartered August 17, 2012 at 12:51 pm

I fought the Lawsky and the Lawsky won.

(HT Jonathan Weil, music video here.)

Compulsory ethics training for bankers July 19, 2012 at 3:56 pm

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.

Does my corporation look fat in this? July 10, 2012 at 8:01 am

The Shard of Babel

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.

Filed under ‘F’ for forget June 30, 2012 at 10:30 am

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.

Li-what? June 28, 2012 at 7:22 am

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.