Does Lynton Jones even know what a hybrid ABS CDO is?

There is a mind-bogglingly deceptive report issued by the City of London blaming the crisis on "over leveraged" ABS CDOs and claiming that this is evidence that credit default swaps did not lie at the heart of the crisis. This is a ridiculous point of view. Credit default swaps were the tool used by ABS CDOs to become over leveraged. While it is possible to argue that certain categories of credit default swaps are not subject to abuse (e.g. that this was a problem of index CDS and that single-name CDS are inherently safer products) or that some targeted forms of regulation are sufficient to address the problem, it is dumbfounding for someone to claim that the crisis was caused by CDOs and not by the credit default swaps they used to become overleveraged.

The confusion created by this misleading report has already led the FT to publish a commentary by someone who clearly does not understand how ABS CDOs were structured because he claims based on the City of London report: "Let’s start with the simple proposition, which seems to be almost universally accepted, that the OTC markets in credit derivatives were one of the main causes of the crisis. The City of London report utterly refutes this claim."

Why are assets toxic?

An explanation for those who can’t understand how so many assets backed by mortgages can be worth nothing at all

From 2005 through the first half of 2007 approximately $2.8 trillion in mortgage backed securities were issued by the private sector. These securities were backed by $1.1 trillion in sub-prime loans, $0.9 trillion in Alt-A loans and $0.6 trillion in prime jumbo loans (and $0.2 trillion in “other” loans). Data in intro here.

I estimate that these $2 trillion in non-prime loans and $0.6 trillion in prime jumbo loans back $4.1 trillion in AAA mortgage related securities. How is it possible to have more AAA assets than underlying loans? Through the magic of credit default swaps.

I should be clear, however: I am including in my $4.1 trillion figure $1.75 trillion of unfunded tranches of mortgage backed securities and CDOs. The data on mortgage backed securities and CDOs that is reported almost never includes unfunded tranches, because these tranches are more comparable to insurance contracts than to bonds. I include them in my estimate of triple A “assets”, because these insurance contracts can result in losses that appear on financial institution balance sheets, just as if they were funded tranches of CDOs.

Credit default swaps were used in two ways to increase the quantity of mortgage related securities available to investors. CDOs sold credit default swap protection on mortgage backed securities in order to increase their exposure to the mortgage market and CDOs bought credit default swap protection from highly rated financial institutions in lieu of selling their senior-most tranches to cash investors. (Some mortgage backed securities did the same on mortgage loans, but since the process was most commonly used by CDOs, I will refer only to CDOs from here on.)

To understand what was going on, you need to realize that mortgage securities were the hot product of the mid-naughties. Mortgages, and especially high-yield mortgages and mortgage backed securities, were in such demand that the average structured financier simply could not find enough for the CDOs he wanted to ramp up. In 2005 innovation in the credit default swap market opened up the possibility that a structured financier could create a CDO that was constructed of 10% mortgage backed securities backed by real loans (known as cash assets) and 90% credit default swaps (known as synthetic assets). Credit default swaps make a payment when the mortgage backed security referenced by the swap defaults. The investor was taking on a risk comparable to a 100% cash CDO, but the financier only needed to purchase one-tenth the quantity of mortgage backed securities he had had to find for a comparable CDO in 2004. The other nine tenths of the investors’ exposure came from using credit default swaps to reference mortgage backed securities that had already been packaged into other CDOs. Credit default swaps on mortgage backed securities made life a lot easier for structured financiers.

One consequence of the use of synthetic assets is, however, that more than one investor has exposure to each subprime mortgage backed security and thus to each underlying subprime loan. Another consequence is that structured financiers did not need cash to buy 100% of the assets in the CDO. Most credit default swaps are at least partially unfunded. This means that the seller of CDS protection promises to come up with cash in case of a default, but does not post cash to guarantee his capacity to do so when he signs the contract. When a CDO included synthetic assets, the structured financier only needed to raise enough cash – or sell enough tranches of the CDO – to cover the costs of the cash assets. You may ask, “But what’s the point of creating this huge CDO, if you’re only going to bother to fund 10% of the tranches?” The other 90% of the CDO, specifically the last-to-take-losses tranche of the CDO, could be “sold” to a large financial institution, like AIG or a monoline insurance company, or even held at the originating bank (e.g. UBS). That is, the financial institution would sell credit default protection to the CDO to cover any losses that were not covered by cash investors.

Whenever you hear someone talk about a “super senior” tranche of a security, this is precisely what they mean – some financial institution has written a credit default swap promising to pay up if defaults exceed the amount covered by the cash investors in the security. Super senior tranches of mortgage backed securities and CDOs are almost never funded.

If it happened that a structured financier had a CDO with more cash investors than cash assets, the extra cash was stored in “safe assets”, such as Treasury or agency securities or guaranteed investment contracts (GICs) issued by large insurance companies.

Now, perhaps, you begin to understand how it is possible for $2.6 trillion in mortgage loans to back $4.1 trillion in AAA securities. Quite a few of those securities were never funded and are really just promises to make a payment when there is a default on a referenced mortgage.

It’s also important to understand that the cash investors in CDOs – those who believed they were buying a “mortgage backed bond” – are going to be the first to lose their money. Why? Because there are many different classes of AAA securities – and it is the financial institutions that sold super senior credit default swap insurance that have a senior claim to any loans that do not default or that have significant recovery. The cash investors in every case bought subordinate AAA CDO securities that are guaranteed to be wiped out if defaults rise beyond a certain level. (Diagram 1 is drawn to scale, so that you can see visually the fraction of losses that will wipe out the subordinate AAA tranche.)

Notice something else about the consequences of this CDO structure given the housing crisis. As it is the super senior counterparties who have first claim to the underlying value of the mortgages, all that underlying value is likely to do is to reduce the amount that the super senior counterparties have to pay out in “insurance”. Since these counterparties initially assumed that there was almost no likelihood that they would make any payment at all, they were never prepared to pay out the whole notional value of the swap.

Thus, when spectators assume that the losses can’t really be too bad, because after all these are assets backed by real estate and there will be some recovery, they are failing to understand the nature of the ABS CDO market: (1) because the CDOs were built on high yield MBS tranches, their value can be wiped out entirely if sub-prime losses exceed 25%, Alt-A losses exceed 10% and Prime Jumbo losses exceed 3%; and (2) the super senior counterparties did not provision for making payment on their obligations. Whereas the cash investors have already put up cash that may be lost, the super senior counterparties will need to come up with the cash as defaults are recognized. Thus the super senior counterparties face not only losses on the balance sheet reducing their equity, but also a liquidity squeeze as they are forced to make payments on more than $1 trillion of swap obligations.

AIG was the first to be caught by this liquidity squeeze, but the monoline insurers are still struggling to manage the problem; the Swiss National Bank stepped in to save UBS from its embarrassments; and Citigroup had to take some super senior swaps on balance sheet in 2007 when its asset backed commercial paper conduits began to implode. Furthermore, a complete breakdown of the financial institutions exposed to super senior cash calls has yet to be made public.

Secondly, some mortgage backed securities have the same CDS based super senior structure as CDOs. While I have only located one explicit example of such an MBS (BSARM 2006-2 discussed in “Bear Stearns Quick Guide to Non-Agency Mortgage Backed Securities”) and have found no data on this issue, it was widely recognized that super senior MBS was being issued. Ominously, BSARM 2006-2 had a super senior tranche that amounted to more than 90% of the total value of the MBS. In diagram 1, I have guesstimated that $0.5 trillion of super senior swaps on MBS were issued. This would mean that in addition to the funded MBS on which we have data, there was another 20% of unfunded MBS issued.

Diagram 1 shows my estimate of the AAA assets backed by the $2.6 trillion in mortgages loans that got packaged into mortgage backed securities from 2005 through mid 2007. Diagram 2 shows the consequences of 25% losses on subprime loans, 15% losses on Alt A loans and 3% losses on prime jumbo loans.

The basic story is explained clearly in Fabozzi. My estimate of super senior ABS CDOs backed by MBS is derived as follows: From SIFMA we know that $685 billion in funded structured finance CDO tranches were issued from 2005 through 2007 Q2. I assume that 80% of the structured finance products backing these CDOs were MBS (see Fabozzi p. 175) giving us $540 billion of “mortgage backed” funded CDO tranches. I then assume that 70% of the ABS CDO structure was the unfunded super senior tranche (see Fabozzi p. 142) resulting in a total – i.e. funded plus unfunded – "mortgage backed" ABS CDO issuance of $1.8 trillion.

CDS "spread trades" and bubbles

A month or so ago there was some discussion of the "end of the world" trade. People have been trading credit default swaps (CDS) on the United States – these swaps are basically insurance against the possibility that the US defaults on its bonds – and to no one’s surprise the premium on this insurance has been going up lately. The trade in this product bewilders many for the simple reason that if the US were to default on its bonds, financial markets would be in such disarray that there is no reason to believe that any major investment bank or other seller of protection would be able to honor the insurance policy. That’s why CDS on the US are called the “end of the world” trade.

In response to the criticism of the trade, several financial commentators observed that these are in fact spread trades. (Here’s a particularly snarky example.) Because the premium is expected to go up, say from 0.7% to 0.8% over the period of a month, anyone who buys the contract today with the 0.7% premium will be due some collateral from the protection seller if the premium does in fact go up to 0.8%. (On the other hand, if the premium falls to 0.6%, the buyer of the contract will have to post collateral.)

Thus, someone who’s buying the CDS for a spread trade wants to receive collateral in case the premium on the contract goes up. One reason to do this would be to hedge: If you own Treasury bonds and are worried that interest rates will go up due to default risk and reduce the value of the bonds – the CDS can protect you from posting a mark-to-market loss on your balance sheet. But there’s a problem with this logic – interest rate swaps are a better way to protect against this possibility because they will compensate for a fall in the value of the Treasuries, whether or not the fall is due to a change in default risk. Furthermore the market in interest rate swaps is extremely deep, so the cost of entering into the interest rate swap is likely to be less than that of the CDS.

So what’s the other reason someone might buy a CDS on the US for a spread trade? To speculate on the movement of the CDS premium – if the premium moves as predicted, you can take advantage of the new premium by selling a contract at a higher premium than you are paying for a comparable insurance policy. Theoretically if there is a default requiring payment, you can simply pass on the payment that you receive from the bank that sold you protection. (Of course, this is the “end of the world” trade, so you’re probably thinking that if a default takes place, you may not get paid by the bank and you may not be able to honor your own obligations, but presumably this is such an apocalyptic scenario that it’s not really worth worrying about.)

I think the important question to ask is: What do spread trades on CDS on the US tell us about the market? They prove that there is a bubble in this CDS market.

People are trading something that they know has no fundamental value, in hopes of reaping short-term gains. Of course, the fact that the contract has no fundamental value means that someone will be caught at the top of the bubble, paying a high price for a valueless contract.

One phenomenon that supports this bubble is that, if the premium does rise, the value of the contract will go up and the buyer of the contract will benefit from short term accounting profits. The fact that everyone knows that this profit will disappear over the long-term, is a sign that these firms are “gambling for resurrection”. If they can make it through the short-term without declaring bankruptcy, they hope that longer-term investments or gambles will pay off allowing them to survive the crisis. On the other hand, they’re paying a premium today to preserve that possibility.

Who is selling the CDS on the US? Anyone with the balance sheet capacity to carry the interim losses that will have to be posted to the balance sheet if the premium goes up.

So, yes, it is true that “CDS on US government debt are spread products,” but this fact is itself a sign of how very, very sick our financial market are right now. It’s also proof positive that CDS are not always a good way to price default risk. The “end of the world” trade is a bubble and when it pops someone is sure to end up posting losses.

An invitation from the Banking Lobby: Enter the Matrix

I've been reading Congressional testimony on derivatives and I couldn't help but imagine the initial sales talk that took place some time before the action in The Matrix.

While credit derivatives are often pejoratively described in the media as a “bet”, it is important to realize that one could equally describe all investments as “bets”. When we buy the stock of a corporation, we are “betting” that the stock will be worth more in the future than what we paid.

The matrix has been carefully designed to simulate the world with which you are familiar. Any differences you perceive are not actually differences ...

The fact that the underlying credit is NOT a party to the agreement and, further, that neither the protection buyer nor the protection seller needs to own the debt of the entity, has also recently been subject to a great deal of media hyperbole. This fact is frequently and shrilly cited as evidence that credit derivatives are a “bet”. But exactly the same statement could be made about futures contracts or stock options – neither the purchaser or the seller of those contracts needs to hold a position in the underlying commodity or stock

You may be familiar with the matrix already in the form of an alternate reality games: there is really no need to distinguish between the matrix and harmless entertainment.

Consider Bank B which wants to diversify its credit exposure but does not have a relationship with the quality of credits it desires. Bank B can sell protection through a credit default swap as an alternative to making loans or buying bonds. This is economically equivalent to lending directly to the desired credits. [Read: While we don't actually lend any money, our derivatives are "economically equivalent to lending".]

When you enter the matrix we can assure you that you and your constituents will not notice that anything has changed.

It is important to remember that credit default swaps, like all derivative contracts, are zero sum contracts – the loss of one party in the contract exactly equals the gain of the other party. In aggregate, therefore, the losses incurred by protection providers equal the gains realized by protection buyers, making the overall CDS market a “closed system”, where gross losses equal gross gains, and both, when added, net to zero. This is in contrast to the cash bond market where credit losses result in permanent loss of value. [Read: Since it is unimaginable for a counterparty to go bankrupt, we have successfully created a financial product with no possibility of "permanent loss".]

Moving to the matrix brings with it great advantages. In a world without gravity, you can jump tall buildings at a single bound ...

The actual number that we should focus on is the gross replacement value of all outstanding credit default swaps, which according to the BBA was a little over $2 trillion at the end of 2007, or just under 3.5% of the notional amount for that period. That number represents the cost of replacing all the existing contracts in the market, just as the market price of an equity security represents the price at which it can be bought or sold in the open market. It is equal to the difference between the present value of fixed-rate premium payments to be made by protection buyers and the present value of the credit event-driven payments that the market expects will be made by protection sellers over the life of the swaps. [Read: Since everybody knows that we have perfected the models used to determine expected losses, you can feel confident that our prices are at least as accurate as simple stock market valuations.]

... or even dodge bullets.

In fact, according to the BBA, dealer positions represent more than 50% of the
of the credit default swap market and, as can best be determined from public
disclosures, have nearly equally balanced CDS exposures, consistent with the
dealer business model.

What? You're worried that when you and your constituents are all in the matrix, you'll be too dependent on the machines. Don't be ridiculous. As best can be determined from public disclosures, the machines are behaving consistent with our expectations. What could possibly go wrong?

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.”