The document that explains it all

From a white paper on AIGFP's employee retention plan posted on the web by Fox News:

AIGFP’s derivatives portfolio stands at about $1.6 trillion and remains a significant risk. Failure to pay the required retention payments therefore could have very significant business ramifications.

For example, AIGFP is a party to derivative and structured transactions, guaranteed by AIG, that allow counterparties to terminate in the event of a “cross default” by AIGFP or AIG. A cross default in many of these transactions is defined as a failure by AIGFP to make one or more payments in an amount that exceeds a threshold of $25 million.

In the event a counterparty elects to terminate a transaction early, such transaction will be terminated at its replacement value, less any previously posted collateral. Due to current market conditions, it is not possible to reliably estimate the replacement cost of these transactions. However, the size of the portfolio with these types of provisions is in the several hundreds of billions of dollars and a cross-default in this portfolio could trigger other cross-defaults over the entire portfolio of AIGFP.

There are also substantial risks related to the hedging of AIGFP’s various books. Although we view the large-market risk books at AIGFP as generally well hedged, the hedging is dynamic – that is, it must be monitored and adjusted continuously. To the extent that AIGFP were to lose traders who currently oversee complicated though familiar positions and know how to hedge the book, gaps in hedging could result in significant losses. This is driven to some extent by the size of the portfolios. In the interest rate book, for example, a move in market interest rates of just one basis point – that is 0.01% or one-100th of one percent – could result in a change in value of $700 million dollars if the book were not hedged. It has virtually no impact on the hedged book. There are similar exposures in the foreign exchange, commodities and equity derivatives books.

What does this mean: Bankruptcy, nationalization, the abrogation of any AIG contract worth over $25 million are all unthinkable. Why? Because the changes to the bankruptcy law that were enacted between 1982 and 2005 have privileged derivative counterparties to such an extent that any default will allow counterparties to terminate the derivative contracts.

While the laws imply that termination will involve careful netting of contracts (that is both contracts that are in the money and those that are out of the money will be terminated and then offset against each other), it is not clear to me that under ISDA protocols a derivative counterparty is required to terminate all contracts. For example, the wording above implies that AIGs counterparties have the right, but not the obligation to terminate derivative contracts. If this is indeed the case, then these counterparties are likely to argue that they have a duty to shareholders to selectively terminate those contracts that are in the money, while leaving contracts that are out of the money in place. In this circumstance the value of AIGFP's assets are likely to fall well below zero for the simple reason that AIG will be stripped of its hedges, except where they are losing money.

The preceding analysis may be wrong because I have never read the ISDA protocols. However, even if the ISDA protocols force each counterparty to either terminate all derivatives contracts with AIG or none of them in the event of a default, such a termination would strip AIG of its hedges with a potentially devastating effect on its balance sheet. (Recalling however that AIG's insurance subsidiaries may well be protected by strict regulation from the debacle.)

Why are regulators and policy-makers behaving as though firms such as AIG are holding a gun to their heads? Because the US bankruptcy law has been rewritten so that every big derivative trading financial firm is a time bomb waiting to explode. Somebody needs to defuse these bombs -- and I suspect that the only entity with that authority is Congress. The law needs to be revised so that the only circumstance in which a counterparty is granted the right to terminate derivative contracts in the event of a cross default is when this right is granted under the rules of an exchange regulated by the CFTC.

Let us not forget how these new bankruptcy laws got passed. For the most part our Congressmen and women felt that the regulation of derivative contracts was such a complex problem that only a limited group of experts could understand it. Unfortunately our regulators never really got up to speed on derivatives and also trusted the judgment of a limited group of experts. Who were these experts? Members of the financial industry itself. In particular the ISDA weighed in in support of every single one of these bankruptcy amendments.

In other words financial industry experts used their expertise to convince Congress to pass laws that gave their firms extraordinary privileges under the new bankruptcy law, in every instance resulting in a de facto taking of property from bond investors who would otherwise be senior to the derivative counterparties. Now these same experts are claiming that the government needs to go into debt to the tune of multiple trillions of dollars in order to protect the sanctity of contracts. Clearly legislative takings are okay only if they affect Main Street investors, not if they affect Wall Street.

It is time for someone to call bullshit and put an end to the extortionate scam that underlies the modern American financial industry.

Is it time to repeal the derivative related bankruptcy amendments of 1982, 1984, 1990 and 2005?

Economics of contempt states:

I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. ...

The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps.

The last paragraph is very misleading. An exemption for derivatives was first enacted in the United States when the bankruptcy code was rewritten in 1978. The exemption was put in place so that counterparties to regulated, exchange traded futures contracts were guaranteed the right to foreclose on collateral and terminate the account of an entity that declared bankruptcy. The reason for this is that daily marking-to-market and margining (i.e. posting collateral) of positions is the mechanism exchanges use to ensure that market participants can honor their obligations. The capacity for the receiver in a bankruptcy to void margin transactions could potentially create a risk of insolvency for the exchange itself. In other words, there is indeed a genuine role for carefully constructed exceptions for certain derivatives to standard bankruptcy procedures.

What happened in 1982, 1984 and 1990 is that the financial industry argued that preferential bankruptcy treatment for exchange traded derivatives created a competitive disadvantage for over-the-counter derivatives and slowly but surely additional derivative contracts were granted safe harbor against standard provisions of the bankruptcy code too. The zeitgeist that viewed unregulated financial innovation as a purely beneficial outcome of free markets undoubtedly contributed to the steady relaxation of the law.

The argument that the 2005 bankruptcy act was just a minor adjustment to derivatives laws is simply false. The most extraordinary change took place in the area of repo contracts, but there is also a strong argument that credit default swaps were not in fact covered by earlier amendments. (A repo contract is sale and repurchase agreement, which functions just like a short-term collateralized loan.) For a thorough discussion of changes due to the 2005 bankruptcy act, see Shmuel Vasser.

The 2005 Bankruptcy Act and the repo market

According to Vasser:

Prior to the 2005 amendments, only a narrow set of securities could have been used for the repo to qualify as a safe harbor transaction. (footnote 33: These were certificates of deposit, eligible bankers' acceptances, or securities representing direct obligations of, or that are fully guaranteed by the U.S. or a U.S. agency.)

In 2005 Congress expanded the definition of a repurchase agreement eligible for safe harbor to include residential mortgage backed securities (RMBS) and derivatives on RMBS. In case you're wondering how that worked out, take a look at the table on page 11 of this paper by Gary Gorton. By July 2007 financial firms were regularly getting 100% financing against investment grade CDO collateral. One inevitable aspect of the financial crisis was the movement to more realistic haircuts on repos.

Unfortunately one of the terms used when expanding repurchase agreements to include MBS in the 2005 law was "mortgage related security." I suspect that any member of Congress who read this passage did not understand that a mortgage related security may be synthetic, that is, it may be a CDO that sells credit default swap "insurance" on a MBS and establishes some value for the CDO by positing a payout likelihood for the swap and netting this against the value of the insurance premiums. Thus a financial firm that writes an insurance policy (via a special purpose entity) was able to borrow 100% of the putative value of that "asset".

Guess what firm thought that CDO repos were a good way to finance its business: Bear Stearns. In their April 2008 congressional testimony Cox and Bernanke express absolute bewilderment about how the repo market completely dried up for Bear. Hmm, I wonder whether CDO repo markets would have grown as big and unstable as they did, if the 2005 bankruptcy act hadn't been passed and if only government and agency paper were eligible for safe harbor under the bankruptcy code.

The 2005 Bankruptcy Act and credit default swaps

Now let's talk about the extension of the derivative safe harbor provisions in the Bankruptcy code to include credit default swaps. The 1980s law that exempted interest rate swap contracts from the standard provisions of the bankruptcy code included the phrase "or any other similar agreement." The problem for financiers was that the only similarity between interest rate swaps and credit default swaps is that they both are financial contracts with the term "swap" in their names. Since common law requires courts to look at the economic substance of a transaction, there was always a strong possibility that some judge would fail to see the "similarity" between a contract that involved a repeated exchange of variable payments and a contract that was in substance an insurance contract, where the payments made by the two parties were separated over time. Thus, it was only with the passage of the 2005 bankruptcy act that a financial market participant could be confident that credit default swaps were exempt from the standard provisions of the bankruptcy code.

The 2005 Bankruptcy Act and systemic risk

Needless to say, plenty of people realized that giving special privileges under bankruptcy law to over the counter derivatives is just as likely to increase systemic risk as to reduce it.

Economists Robert Bliss and George Kaufman:

We conclude that the systemic risk reduction claims often made for close-out
netting and collateral protection appear at a minimum to have been over stated. Systemic risk is in part made more likely as a result of these protections, but then so also are the benefits obtained from a more efficient market that is based on these same protections. The combined use of these three provisions represent a two-edged sword that cuts both ways.

Bliss and Kaufman make the point that should have been obvious to everybody: When you reduce the likelihood that an individual firm will face the costs of counterparty risk, you may find that you increase the size of the market so much that there is no reduction in counterparty risk in the aggregate.

Law professors Franklin Edwards and Edward Morrison had a different concern:

as the LTCM experience demonstrates, permitting the immediate liquidation of a large financial institution counterparty such as LTCM can generate another form of systemic risk, namely the risk that a a run by derivatives counterparties on the debtor will itself destabilize financial markets.

This appears to describe precisely what happened when Lehman Brothers failed.

Finally, we have Shmuel Vasser again:

[I]n many derivative transactions the bankruptcy filing merely subjects the non-debtor counterparty ... to a risk of loss, not an uncommon situation for parties with business relationships with a failed enterprise. The safe harbor provisions change all of that.

Assume that a debtor uses large amounts of metal in its manufacturing process and to protect itself from price fluctuations has entered into a long term forward for its metal requirements. At the time of its bankruptcy, metal prices are significantly higher thus making the forward a highly valuable estate asset, and potentially making its reorganization more likely. Not so; upon bankruptcy the seller can terminate the forward allowing it to obtain market prices for the metal. If, however, at the time of bankruptcy metal prices are lower than the contract price, the non-debtor counterparty has the option not to terminate the forward, and file rejection damage claim should the debtor decide to reject the forward. As this example makes clear, only the non-debtor counterparty obtains the upside of a derivative in a bankruptcy, not the debtor.

... Now assume, however, that the debtor in the example above is a major corporation with tens of thousands of employees, tens of billions of dollars in debt securities outstanding, millions of public shareholders including pension funds and billions of dollars of notional amount of derivatives -- will the application of the safe harbor provisions in such a case serve to protect financial markets from systemic risk or stress them even further? Time will tell.

Vasser points out that the "safe harbor" provisions for derivatives in the bankruptcy code will result in a bankrupt firm being stripped by counterparties of its hedges and thus preclude a Chapter 11 reorganization of the firm. The fact that a financial firm will be forced to declare Chapter 7 bankruptcy (that is to liquidate) is common knowledge. What is not common knowledge is the fact that stripping a financial firm of all its hedges before liquidation is very likely to leave the firm with almost no value for bondholders to recover.

Thus, the derivative related revisions to the bankruptcy code of 1982, 1984, 1990 and their final apotheosis in 2005 created a huge class of secured creditors which has priority in bankruptcy over unsecured creditors (i.e. bondholders). Effectively bonds in financial institutions (and other firms with significant derivative exposure) were converted by revisions to the bankruptcy law into a senior form of equity. When this fact is fully understood, it is very likely financial firms will no longer be able to raise money on commercial paper and bond markets.

In short, those who argue that the government needs to take action X, Y or Z in order for financial firms to fund themselves on private capital or debt markets are ignoring the underlying problem. Until the special privileges granted to over the counter derivatives contracts are repealed by Congress, there is no reason to believe that financial firms will ever be able to raise money on capital or debt markets again in the absence of a government guarantee – for the simple reason that once derivative counterparties are done with a bankrupt financial firm there is not likely to be much left for residual claimants.

This is the true lesson to be drawn from the failure of Lehman Brothers and the constant refrain “No More Lehmans”: It may be time to repeal some of the special privileges granted to over the counter derivatives in the 1982, 1984, 1990 and 2005 bankruptcy law amendments.

How bad is public-private investment?

The Obama administration is taking some flak from economists for its proposal to finance private purchases of toxic assets using non-recourse loans. I, however, can understand the logic behind the proposal. If you believe that the collapse in credit is overshooting, so that the shrinking of the intermediated money supply is more than would be required in a normal environment, then this policy makes sense. (It seems to me that everyone who supports fiscal stimulus is implicitly taking this point of view.) In short there is some reasonable leverage ratio for non-bank financial institutions where the asset to equity ratio lies, I would estimate, between 4 and 10. If non-bank financial firms are being forced to a leverage ratio lower than this, then an unreasonable amount of leverage is being squeezed out of the financial system, and we are failing to use our savings efficiently. In other words, it is possible that some well-managed hedge funds (et al.) are in fact underleveraged right now. For this reason, the government may choose to step in to support asset values by deliberately increasing the amount of leverage in the financial system.

While this is certainly a somewhat risky position for the government to take, if the policy is implemented with extreme care, it may be successful. Here are the caveats I would propose to help establish "market" prices in our current not-so-market financial world.

(i) The fraction of money that private funds put up needs to be high (25% sounds about right to me) and that private money should be in a first-to-lose, last-to-gain position -- in other words, all income and principle needs to go to the government before the private investors get a penny. Furthermore, there need to be safeguards in place to ensure that the private stake is real. (Maybe, the crisis has made me cynical, but I genuinely wonder whether its possible for the government to be tricked into putting up close to 100% of the funding.)

(ii) No synthetic assets should be funded using this mechanism. If the government wants to support the purchase of synthetics, it should do so only on the basis of full recourse loans to well-capitalized entities. The reason for this is simple: As a matter of market economics, one should assume that on Sept. 17, the day AIG was bailed out, there was a total domino-like collapse of the investment banks and any bank obligation that is not backed by real collateral was left with nothing more than the option value of government intervention. Thus, on Sept. 17 the intrinsic value of all CDS contracts should be assumed to have fallen to the amount of collateral that was posted as of that date.

If the government starts offering non-recourse loans for the purchase of assets that have value only because of the option value of government action, it will be an exercise in the absurd. Effectively the only reason to buy synthetic assets is because the purchaser believes that the government will be so embarrassed by the losses on the nonrecourse loans that will be incurred by a government failure to support the value of CDS that the government will engage in a costly taxpayer funded bailout in order to cover up its own mistakes. Trust me, we don't want to go there.

Update 3-4-09: I reread the post several times yesterday asking myself whether it wasn't maybe a little over the top, but decided to leave it alone. And then today I find that El-Erian agrees with me: “You can no longer predict asset value without thinking about the role of governments. Governments are no longer referees, they are players.”