Right, Because The Markets Would Benefit From Confusion And Uncertainty...

Josh Marshall discovers that securities lending, derivatives, and collateral are related, and opines that this is a bad thing:

I'm sure the knowledgeable people already know this. But it turns out that one of the features of the 2005 Bankruptcy bill was to put derivative counter parties at the front of the line ahead of other creditors in bankruptcy proceedings. Actually, from what I can tell, they don't just go to the head of the line. They got to skip the line entirely. As the Financial Times noted last fall, "the 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company's assets until a court decides how to apportion them among creditors."

I infer that Dr. Marshall has a clear mental image of unscrupulous peddlers of credit derivatives elbowing aside worthy grandmothers and charitable trustees to claim a failing firm's assets, leaving these good people on the street.

Well.  First of all, derivative counterparties not secured by collateral are treated as run-of-the-mill unsecured creditors, so they are expected to wait politely in line with any grannies in the crowd.

Secondly, people with accounts at a broker such as Lehman are protected by the SIPC and are not creditors of that broker; unsecured creditors of a firm such as Lehman are the few and the proud; most of what these highly levered firms do is on a collateralized basis.  As an example, the Reserve Primary Fund was buying unsecured Lehman commercial paper at a premium rate last fall and got toasted - oops.  The Reserve fund weighed the premium rate on their investment against the "too big to fail" notion and guessed wrong, but why that entitles them to be put in a creditor's pot with people who took a lower rate on a collateralized repo transaction or only agreed to do business with Lehman on a secured basis is beyond me.

Derivatives contracts secured by collateral (which would be the vast majority of the swaps done with, e.g., Lehman) are treated in the same fashion as repo loans (a repo loan is a short term loan collateralized by securities).  From a recent article:

The bankruptcy sale of Lehman Brothers Holdings Inc. illustrates the unique status of repurchase agreements under the Bankruptcy Code.

...

Since its enactment, the Bankruptcy Code has recognized a tension between the "time out" generally imposed on creditors of a bankrupt debtor and the needs of financial market participants for an immediate exit from certain types of financial contracts. Immediate exit is often necessary to preserve liquidity and to prevent the possibility of systematic market failure. The Bankruptcy Code contains safe harbors that give nondebtor counterparties special rights under certain categories of financial transactions: most importantly, the ability to terminate the contract governing a transaction upon the commencement of a bankruptcy case and to pursue post-default remedies.

The original version of the Bankruptcy Code did not explicitly recognize repos, nor did it entitle them to safe harbor protection. Congress, as part of the 1984 Bankruptcy Code amendments, expressly defined repurchase transactions and gave safe harbor protection to agreements falling under that definition and significantly expanded the definition of repurchase transactions in 2005.

The relevant regulators such as the Fed and SEC are well aware of the use and legal treatment of collateral as grease for the financial system and support these rules.  And FWIW, collateral used this way mimics the use of mark-to-mark margining on an exchange; with exchange traded contracts a dealer puts up cash to cover that day's losses (and can take out cash to collect on that day's gains).  The exchange is not expected to wait for months while a bankruptcy judge opines on whether the exchange is in fact entitled to retain any cash so posted.  In the same way, a derivatives dealer may be obliged to post collateral against (net) losing trading position; unless the goal is to shut down those markets (and it might be!), failing to recognize the rights of collateral holders is more likely to send shock waves through the system, as people who thought their position was secured are informed that it is not.

By way of example, here is a Marshall reader who thinks that gumming up these contracts would be good social policy.  Its a interesting approach - neither Congress nor the regulators was willing to declare these contracts unacceptable back in the day, but after the fact they will work to have them made unenforceable.  Hmm - if Bush did this it would be shredding the Constitution, but fortunately this would be happening under Obama, where we are a nation of men, not laws.

INTERESTING BUT MUDDLED:

Josh Marshall includes an interesting reader email from which I snip this:

Additionally, naming AIG's counterparties without knowing/naming those counterparties' counterparties and clients would be at best useless, and very likely dangerous. Let's say Geithner acknowledges that Big French Bank is a significant AIG counterparty. (Likely, but I have no direct knowledge.) BFB then issues a statement confirming this, but stating it was structuring deals for its clients, who bear all the risk on the deals, and who it can't name due to confidentiality clauses. Since everyone knows BFB specialized in setting up derivatives transactions for state-affiliated banks in Central and Eastern Europe, these already wobbly institutions start to face runs. In some cases this leads to actual riots in the streets, especially since the governments there don't have the reserves to help out. If you're Tim Geithner, do you risk it? Or do you grit your teeth and let a bunch of senators call you a scumbag for a few more hours?

Well.  If the Big French Bank is AIG's counterparty, then I am at a loss to interpret "it was structuring deals for its clients, who bear all the risk on the deals".  If the clients have a contract with the Big French Bank then the BFB is obliged to perform whether AIG performs or not (ad we hope its capital is adequate); if the clients have AIG as a contractual counterparty then the BFB is not AIG's counterparty.

Now it may well be that an AIG default would inflict losses on the BFB so severe that it would be unable to continue; this is the sort of systemic risk worrying regulators. 

The WSJ names some names:

The beneficiaries of the government's bailout of American International Group Inc. include at least two dozen U.S. and foreign financial institutions that have been paid roughly $50 billion since the Federal Reserve first extended aid to the insurance giant.

Among those institutions are Goldman Sachs Group Inc. and Germany's Deutsche Bank AG, each of which received roughly $6 billion in payments between mid-September and December 2008, according to a confidential document and people familiar with the matter.

Other banks that received large payouts from AIG late last year include Merrill Lynch, now part of Bank of America Corp., and French bank Société Générale SA.

More than a dozen firms with smaller exposures to AIG also received payouts, including Morgan Stanley, Royal Bank of Scotland Group PLC and HSBC Holdings PLC, according to the confidential document.

The names of all of AIG's derivative counterparties and the money they have received from taxpayers still isn't known, but The Wall Street Journal has identified some of them and is publishing others here for the first time.

This will become a political hot potato.  Eventually US lawmakers and taxpayers will focus on the fact thast American International Group has "International" in its name as well as "American"; the dreaded Joe Cassano was based in London and plenty of European banks are riding the AIG bailout.  So who should pony up?  More from the WSJ:

Now, other problems are popping up for AIG. The insurer generated a sizable business helping European banks lower the amount of regulatory capital required to cushion against losses on pools of assets such as mortgages and corporate debt. It did this by writing swaps that effectively insured those assets.

Values of some of those assets are declining, too, forcing AIG to also post collateral against those positions. And if the portfolios incur losses, AIG will have to compensate the banks.

AIG had seen this business as a relatively safe bet for the company and its investors. The structures were designed to allow European banks to shuck aside high capital costs. A change in capital rules has meant that the AIG protection no longer meets regulatory requirements.

European regulators were complicit on the way up, yes?

[END OF THREAD]

Comments

[mel]

TM-

This, you must admit, is a bit of a gross simplification of the multiple market making activities that happen in a large Broker/Dealer. The array of derivatives traded within the environs of a B/D, the collateral used, and in some cases, where none is used (I'll get back to this one), can't be stuffed under one hat and call macaroni.

The Repo market is just that, a marketplace where individuals or institutions can trade various types of securities to cover margin positions, for an overnight lending rate. Exchange based derivatives accept only certain securities for collateral. The are called T-Bills, no messing around. Collateral accepted within a B/D, however, is determined by that B/D and governed (sort of) by the SEC. And this is where things got a bit carried away.

The big profit centers at B/D's are their own product line. And in particular, the ABS and CDS origination desks. The ABS stuff, as you got further and further away from the point of origination, generated higher and higher yielding paper, which allowed for higher and higher fees. Also known as "profit centers".

The pace of origination got so frenetic, and the profits so huge, they started to sell things, as some used car dealers do, with "no money down", or with a loan from the B/D itself, because the customer couldn't come up with the cash just yet. These became side deals that got conveniently stuffed into what are now known to everyone as SIV's. The customer was a business partner, of sorts, with the B/D. Some of these agreements went so far as to guarantee the customer would not be exposed to any losses on the underlying product.

All, until the last, were using collateral, and collateral levels, established, internally, by the B/D's and overseen by the SEC. There was no pecking order for that collateral, in the case of a bankruptcy. This was a particular concern to some large endowments and Trust companies that, as part of their business, have securities lending facilities for those large customers. They don't want to trade their positions, but are willing to lend their securities overnight, for a little extra return on their investments. That's why it was added in 2005, to cover those lenders.

No need to oversimplify something that very definitely isn't so simple.

I think.

[Pofarmer]

All those acronym's just make me think of STD's, which is about what all this derivative trading seems to mimic.

[mel]

Don't get me started. You too can be acronymed.

[bad]

Acronym me Mel.

[mel]

Kool-Aid.

Close enough bad?

And you know why they have no Kool-Aid in Minnesota, 'cause they can't figure out out to get four quarts of water into the little packet.

[mel]

Gotta go.

Later.

[Porchlight]

Minnesota jokes! Are you from Wisconsin or Iowa?

[bad]

Kool-Aid.

I don't get it. Some one help me out.

[bad]

Mel is from Illinois.

[Porchlight]

Ah yes, thanks, bad. I'm sort of from both Minnesota and Illinois. Born in Chicago, but my family is from Minnesota on both sides.

[bad]

Porch, why would Mel call me Kool-Aid?

It has to be 'cause I'm so sweeet......

[DebinNC]

I can't help you, bad. I pictured a turbaned Johnny Carson reading the answer card ["Kool-Aide"]..smiling sweetly while holding the question card to his forehead..ostentatiously opening it, then reading the question ["What are senators Specter, Snow, and Collins drinking?"]

[Ignatz Ratzkywatzky]

It has to be 'cause I'm so sweeet......

And so koool.

[Porchlight]

bad, you're a tall cool sweet drink on a hot day of wading through the blogs. That must be what mel meant. :)

[MayBee]

You are very helpful, too. Thus the "aide".

[bad]

LOL everybody!! When Mel reurns from his Bob the Builder escapades perhaps he will bless us with his knowledge.

He may spank us all....

[Rick Ballard]

It's going to be entertaining to watch the Dems invoke chauvinism on this one. I would note that the Paribas/Fortis card house requires one of those public private props that Turbo envisions.

We should be thankful that the creation of new Ptolemaic economic epicycles is consuming so much of our credentialed economic moron's time. Who knows what mischief they might enter into were they not busily spinning straw into mud?

Consider the possibility that yet another form of economic Black Death device even more deadly than the elegant CDS may have been at the point of release in September.

[TCO]

You're a moron, Maguire. Chapter 11 is way better than propping up losers by wealth transfers from taxpayers to speculators (and keeping failed management in existence). If some counterparties twist in the wind while the 11 goes through...well that's a risk they took too. Let the speculators on derivatives deal with the outfall. Stop the Goldman Sachs bailout. Stop bailing out Warren Buffet. Those guys have enough money. They're Democrats anyhow. And bailouts encourage moral hazard. Come to Jesus workouts send the right message.

And stop trying to reinflate the bubble. THat's moronic. LEt lenders and borrowers make their own arrangements. That's the free market. If risks are high (or borrowers judge them so) then they will require high rates, collateral and "lend less". And vice-a-versa. But the government is moronic to think it can make better risk judgements. We have already demonstrated miserable judgement with all these bailouts like AIG and such which keep coming back for more. Remember the idiots here who thought the market was irrational and that the assets were undervalued and you'd make money on them? HA! Didn't turn out that way, sukkaz.

[Pofarmer]

Hey mel. Have you got an example of the kinds of questions you are considering?

[Charlie (Colorado)]

So, if I'm getting this right, Herr Doktor Marshall is starting from a basic misunderstanding of bankruptcy law in order to put the blame onto a relatively minor clarification of the status of collateralized derivatives that happens to have passed in 2005, rather than the rather more dramatic changes in GAAP and short-selling regulations that happened in 2007.

I wonder why?

[mel]

bad-

The kool-aid acronym was off the cuff and off subject, therefore I, of course, used it. Sole reason, and to sow confusion. The lack of culture you now own, solely, is a derivative of one of the Minnesota/ Iowa humor wars, with which Po would be intimately familiar on a number of levels. As in yogurt has more culture than your state of...

Just having some fun.

I'm not really looking for questions, but suggestions that would tweak someone watching CNBC on the question of government interference in the market place and the concomitant moral hazard of doing so.

You know, simple stuff like that which the White House no doubt thinks about every morning.

[mel]

TCO-

I hear black helicopters.

We better hide.

[davod]

I was just listening to C-Span on the radio (Not much else on Saturday afternoon) while driving.

In response to a question by Senator Kyle suggesting that new taxes on offshore oil and gas producers may be bad for consumers and steps towards energy independence, Geithner said that the country cannot continue to subsidize the oil and gas producers.

No longer tax increases but removal of subsidies.

I wonder if anyone realized how revealing this statement was - Communism or Socialism?

Imposing a tax is now removing a subsidy? Does this mean everything you own belongs to the government?

[bad]

Mel

1. the obvious moral hazard is that it protects idiots from the consequences of their actions while punishing the responsible, thereby reinforcing bad behavior.

2. A free market system doesn't care about gender, race, intelligence, number of appendages, past failures/successes or degree of attractiveness. It cares about providing goods and/or services someone wants and is willing to pay for. Interfering with that concept is racist, sexist, brainist, limbist, and a bunch of other ists.

3. A free market system assumes everyone is capable of succeeding on their own merits. It encourages self-confidence and self reliance.(self-esteem is a good buzzward for pop-psych kinds.) Govt intervention sows seeds of self-doubt and learned helplessness.

[mel]

bad-

Perfect!

davod-

Of course it's their money, they print it don't they?

[bad]

Thanks Mel!!! High praise coming from you, our brilliant man of mystery... except for Daddy....

[pagar]

which the White House no doubt thinks about every morning.

Did I miss something? Do we have some new evidence that there is someone thinking in the WH. I thought the last we heard, they weren't even smart enough to buy a decent gift for a British VIP?

[MayBee]

davod- Ezra Klein is pushing a similar meme right now, about limiting itemized deductions for income earners over $250,000.

He says the government is spending the money it currently lets people via itemizing, and wouldn't it be better for the government to spend it on health care instead?

[mel]

pagar-

Repeat after me.

S.
A.
R.
C.
A.
S.
M.

And it was a perfectly, thoughtful gift for a man who is partially blind. Hope they figure out that formatting issue. Otherwise, they sent him packing with a brand new vinyl paperweight.

[pagar]

Speaking of markets benefiting.

or alternate title: Another vacancy at Treasury.

Treasury Inspector ‘Quits’ In Scandal

Meanwhile, IndyMac customers who lost their savings are demanding answers and are further infuriated after learning Dochow was also the regulator in 1989 who oversaw the failed Lincoln Savings and Loan, a scandal that sent its CEO Charles Keating to prison.

[bad]

Mel to #2 about the moral hazards add age discrimination.