Deus Ex Macchiato

Bloomberg tells us that

The Options Clearing Corp. threatened to liquidate Lehman Brothers Holdings Inc.’s trading positions in the 2008 financial crisis unless Barclays Plc bought its brokerage and took on the defunct firm’s obligations, a lawyer for the U.K. bank told a judge… A similar liquidation of Lehman derivatives the same month by options and futures exchange CME Group Inc. cost Lehman’s creditors $1.2 billion, according to a report by bankruptcy examiner Anton Valukas.

Motivated by this, let me ask a hypothetical question. Suppose a firm has an asset which, were the firm to be a going concern, would produce cashflows with the PV of 100. However, the firm is not a going concern, and on forced sale, the asset is worth 60. A party approaches the liquidator and offers 80. There are no other bidders. Should the liquidator accept?

The standard theory of the duty of liquidators says yes: 80 is more than 60. This, it seems to me on a naive reading of the article (and with the usual I am not a lawyer caveats), is all that is going on here. Barclays offered less than the assets were worth as a going concern, but more than they would likely fetch in a forced sale. It’s tough for the creditors, but not as tough as a forced sale. Going concern value is not the same as forced sale value. Nothing to see here, move on.

Posted in: Clearing and Collateral, Legal Risk and Trade Documentation by David /
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Bloomberg reports:

Warren Buffett’s Berkshire Hathaway Inc., which has more than $60 billion at risk in derivatives, may scale back offering new contracts because of collateral- posting requirements, said a company executive…

“If you are now going to have to post dollar-for-dollar collateral, and you can’t get a price in the market that we think reflects the value of the credit quality of the company, then we wouldn’t take on that risk,” Sokol said yesterday

It is worth recapping what Buffett does in the derivatives space. He writes long dated out of the money OTC options and receives premium, which he invests. Currently he relies on the high credit quality of Berkshire Hathaway to allow him to negotiate contracts without collateral requirements. Therefore Buffett’s entire economic risk, he thinks, is the terminal value of the option: he thinks about it as an insurance contract, arguing that because he does not have to provide collateral, the path to the final value (i.e. the fair value of the option during its life) does not matter. Provided Berkshire remains well capitalised (once the fair value of the option is considered), that is true.

Now, one might argue that this was AIG’s business model in OTC derivatives too, and it didn’t work out so well for them. Fair enough. But my point is a broader one: if you require central clearing, and thus enforce collateral, this business model becomes impossible. Funding collateral is a real economic cost, and it makes Buffett’s business model much more costly and difficult to execute. In other words, one effect of requiring central clearing is that an entire business has been made essentially impossible by regulatory fiat.

I am not saying that regulators should not have the power to do that. But I do think that that power should only be used once they are sure that it is necessary for financial stability, and after considerable debate. To stop not just one firm’s activities but an entire business model just because you happen to prefer central clearing to bilateral OTC contracts seems to me to be a disproportionate reaction. How many other things are going to be ruined in this headlong rush to be seen to be doing something about financial regulation?

Posted in: Clearing and Collateral, Derivatives, Hedging and Convexity by David /
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An interesting article in Risk magazine by Mark Pengelly raises some questions about the range of collateral accepted by some CCPs:

One New York-based head of collateral at a major dealer says the types of collateral often accepted by CCPs can also create wrong-way risk: “If you look at the clearing house structures, the types of collateral that are taken really can have a wrong-way aspect to them. If an equities clearing house is accepting equities as collateral, they have to be pretty well diversified in order to ensure the collateral value isn’t shrinking as the equities are tanking.” As a member of a CCP, the bank has tried to work with clearing houses to get these standards tightened, they add.

The collateral policies of CCPs are not uniform. The rules of the Chicago-based Options Clearing Corporation, which clears futures and options traded on various US exchanges, allow for a variety of different assets to be posted. They include certain equities and corporate bonds, shares in money-market funds, US Treasury bonds, cash, letters of credit and the debt of government-backed mortgage lenders Fannie Mae and Freddie Mac. Frankfurt-based derivatives exchange Eurex says it accepts a “wide range of cash and securities as collateral”… But just as some dealers are nervous about CCPs accepting a wide range of collateral, others are eager that the range of eligible collateral be extended. New York-based International Derivatives Clearing Group, which clears OTC US dollar interest rate swaps, currently only accepts US Treasuries and agency securities. However, the clearing house is looking to extend its range of acceptable collateral to other fixed-income securities. “Clients would like the types of collateral we take to be as broad as possible…” says chief risk officer Michael Dundon.

I am sure that clients want as broad a range of collateral as possible: I’d like to be able to repo out my dry cleaning receipts too. But for a security to be good collateral it must be high quality, low volatility, have low correlation with the exposure (the reverse situation – where the collateral value declines when the counterparty owes more money is wrong way risk), and be subject to an appropriate haircut. CCPs are rushing to gain new business at the moment as it is clear that there will be only a small number of winners in each asset class, perhaps only one. Everyone wants to be the winner. There are two obvious ways to compete: lower initial margin, and accepting a wider range of collateral with lower haircuts. Both of these have the potential to increase systemic risk – you can imagine the implications of posting a corporate bond as collateral against a CDS on a highly correlated underlying, for instance, or equities as collateral against equity derivatives. Banks are subject to strict supervision to control this, with the Basel accords containing firm language about wrong way risk. But it seems that things may be a little laxer in the world of CCPs.

Posted in: Clearing and Collateral by David /
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Central clearing and CCPs have been much in the news recently, thanks to their prominent role in US regulatory reform and Basel 3. Some commentators remain skeptical, and I commend both the Streetwise Professor (see for instance here or here) and Jon Gregory (see here) to your attention. Here I am not going to address the debate head on, but rather correct a few misconceptions.

1. Clearing houses reduce risk. Wrong. Clearing houses concentrate risk. Counterparty risk does not go away if you use a clearing house; rather it is all gathered up in one big systemically risky lump.

2. There will be one CCP. Certainly wrong. There will be a diverse architecture of CCPs clearing different products in different regions with some products not clearable anywhere.
3. Central clearing increases netting benefits. Right, provided that the same clearing house is used for everything. But as we point about, there won’t be. In fact, using central clearing might well decrease netting benefits compared with the current OTC market, especially where a clearable trade hedges a non-clearable one.
4. Central clearing is needed for transparency. Wrong. Trade repositaries can provide transparency without requiring central clearing.
5. CCPs have the technology and understanding to clear OTC derivatives. Partially right, but the devil is in the detail. Some CCPs have the technology and understanding to clear some OTC derivatives. Many derivatives will never be liquid enough nor have a visible enough price to be clearable.
6. Central clearing is more legally robust than the OTC market. Wrong. No clearing house anything like the number of legal opinions that their close out procedures work in bankruptcy that the OTC market does.
7. OTC default is the same as CCP default. Wrong. The terms of default vary from CCP to CCP, and do not in general match default under OTC agreements. Therefore a firm can be in default under an OTC and not to a CCP and vice versa.
8. CCPs will cooperate to reduce the impact of multiple clearing venues. Unknown, but just contemplate for a moment the systemic consequences of one CCP putting another into default and shudder.
9. Margin with a CCP is safe. Mostly wrong, especially given that for many (but not all) CCPs, it does not have the same degree of safety as a bank deposit.
10. CCPs will have access to the central bank window in time of trouble. Unclear. Some central banks oppose this.

Factor in CCP competition on margin requirements and the fact that a CCP’s default fund does not cover some risks the CCP might run (such as operational risks including legal risk), and I fear that if central clearing of OTC derivatives is badly implemented, it might leave us in a worse position systemically than we are in today.

Posted in: Clearing and Collateral by David /
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Via Felix Salmon, I picked up a post by the Streetwise Professor on the CME liquidation of Lehman’s positions. Remember that Lehman’s portfolio on the exchange comprised liquid contracts which the exchange might have you believe can easily be valued. Nevertheless, the liquidation of these positions cost Lehman’s estate $1.2B more than its marked value. This reflects the point made in the previous post about closeout always being lower than going concern value.

The Streetwise Prof calls the problem replacement risk:

when somebody defaults, its counterparties have to find new firms to take the place of the defaulter. In stressed market conditions associated with the failure of a major dealer or trader (e.g., LTCM), it is likely that these replacement trades will occur at prices that deviate substantially from the prices prevailing before the default; those stepping in for the defaulter are only willing to trade at far more favorable prices than the pre-default prices.

Well, that’s exactly what happened here. Goldman, DRW, etc., replaced Lehman as the counterparty on these trades, and were only willing to do so at prices that differed substantially from the pre-auction prices. In the event, Lehman’s collateral was sufficient to cover the replacement cost (this can happen in the OTC market too), but it is not outside the realm of possibility that the collateral of a big defaulter would not be sufficient, and that other clearing members would be called on to make up the difference.

This should be a cautionary tale for those hot to force a substantial extension of the use of clearing. Many of the products that are not cleared now, but which would be cleared under mandates, would be less liquid, more difficult to value, and pose risks more difficult to evaluate than currently cleared products like those that Lehman held at CME (and similarly, at LCH.Clearnet’s SwapClear). As a result, any replacement cost problem would likely be more severe than that experienced at CME in 2008, and the risk that collateral would be insufficient would be greater.

Just how much capital, exactly, would the clearing house need to cover replacement risk for all these new contracts it will have to clear?

Posted in: Clearing and Collateral, Derivatives, Hedging and Convexity, Markets by David /
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Many people knew that banks created bonds explicitly for use at the central bank window, and never showed these bonds to the market. It is interesting that the broker/dealers were in on the trick too. Or, at least, one of them was. From page 1393 (I know, I know – but I probably sleep more than Yves Smith) of the Valukas report on Lehman:

Lehman did indeed create securitizations for the PDCF [the FED's primary dealer credit facility] with a view toward treating the new facility as a “warehouse” for its illiquid leveraged loans. In March 2008, Lehman packaged 66  corporate loans to create the “Freedom CLO.” The transaction consisted of two tranches: a $2.26 billion senior note, priced at par, rated single A, and designed to be PDCF eligible, and an unrated $570 million equity tranche. The loans that  Freedom  “repackaged” included high‐yield leveraged loans, which Lehman had difficulty moving off its books…

A 20% haircut on a concentrated illiquid high yield portfolio in exchange for government funding? Not bad at all. And certainly actually selling that senior note at par would have been difficult when Lehman created it in March 2008.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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What do regulators need to be successful? That the regulated are successful. Therefore it is no surprise that a regulator should defend their turf. Gary Gensler however goes further: here is his slick bait and switch in aid of the exchanges.

We’ll start with a classic example of ‘wouldn’t it be nice’:

A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future…

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

The only minor difficulty is that there is already such a framework. It is called the Basel capital accord. It might be inconvenient for Gensler, but we don’t need a new regulatory framework. What we need is for the Americans to apply the framework the rest of the world already uses, and they themselves use for the largest banks, to everybody else. Even if they don’t do that it hardly matters: the vast majority of derivatives are traded by dealers who are subject to Basel capital adequacy rules and to robust conduct of business requirements.

(Now of course Basel is not perfect, as I have argued elsewhere. But to pretend that there isn’t a regulatory framework when there patently is is at best sharp practice and at worst rank dishonesty.)

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction.

How on earth will putting OTCs on exchanges improve transparency? The swaps market is already highly transparent and highly liquid. Moving that would not change anything, except the profitability of exchanges. Some credit derivatives are illiquid: how would putting them on exchange make them more liquid? One needs only look at the stale, unrepresentative prices that exchanges distribute on their existing illiquid contracts to see that simply having a contract on the exchange is no guarantee of liquidity nor of accurate prices.

Trade reporting is important for credit derivatives, and a central counterparty or other counterparty risk reduction technology are also needed. But none of this needs an exchange. In fact the only people who need OTCs to put on exchange are the exchanges themselves and, it seems, their regulator.

Posted in: Clearing and Collateral, Regulation by David /
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Rajiv Sethi writes:

In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role… The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.

Sethi is right: this is important work. What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

Posted in: Clearing and Collateral, Economic Theory by David /
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From Bloomberg:

The vaults of Credito Emiliano SpA hold the pungent gold prized by gourmands around the world — 17,000 tons of parmesan cheese.

The regional bank accepts parmesan as collateral for loans… [its] two climate-controlled warehouses hold about 440,000 wheels worth 132M Euros…

The bank offers loans for as long as 24 months, equal to the time it takes the parmesan to age, at the euro interbank offered rate, plus 0.75-2%.

I love commodities finance. Particularly when you can eat the collateral if the loan goes bad.

Posted in: Clearing and Collateral, Credit by David /
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AIG’s collateral postings after the rescue are well known – essentially the firm was saved so that it could continue to fulfil its obligations to the banking system, notably under the CDS it had written. AIG before the fall has received less attention. But now Bloomberg has done some digging, and the story of the collateral calls that brought AIG down is emerging.

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, … “It was precisely that drain of liquidity to Goldman and SocGen that put AIG in a position of illiquidity and ultimately threw them into the government’s arms,” said Charles Calomiris, a finance professor.

Including collateral from before and after the rescue and payments made by Maiden Lane III, a vehicle created by the Fed to retire the swaps, Goldman Sachs received about $14 billion from AIG, Societe Generale got $16.5 billion, and Deutsche Bank AG received $8.5 billion.

Posted in: CDS and Negative Basis, Clearing and Collateral, Credit, Mother of all Bailouts by David /
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Bloomberg reports:

Credit-default swap clearing would become mandatory under legislation slated to be introduced next month by House of Representatives Agriculture Committee Chairman Collin Peterson.

Not to be outdone,

Peterson’s counterpart in Congress, Senate Agriculture Committee Chairman Tom Harkin, a Democrat from Iowa, last month introduced legislation that would force all over-the-counter trades including credit-default swaps to be traded on an exchange and processed by a clearinghouse.

If this happens, it would be tremendous for London. We will consolidate our lead in credit derivatives, and attract a lot of OTC equity and interest rate derivatives currently traded in the US too. That should cushion Crunch-related job losses a little, at least.

Posted in: Clearing and Collateral by David /
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