By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
In this two part paper, the issues regarding settlement of complex derivatives arrangement revealed by the failure of Lehman Brothers is outlined. Many of the failures affect new regulatory proposals such as the rapid resolution regimes under consideration. The First Part deals with terminating and settling derivative contracts.
A generation was once measured by where they were when an American President was assassinated in Dallas. A newer financial generation measure themselves by where they were when Lehman Brothers filed for bankruptcy protection on 15 September 2008.
The controversial failure of Lehman has become a pivotal point in ideological debates about markets, finance and the role of government. At a more mundane level, Lehman’s bankruptcy points to deeper problems in the “plumbing” of the financial system. The policy debate so far has largely ignored these unfashionable issues.
Refusal to understand these lessons will spawn poor new policies and regulations. The concept of “living wills” for large financial institutions substantially ignores some issues that Lehman’s exposed. Many of these concerns relate to derivatives, especially the settlement of contracts following bankruptcy, documentary uncertainties and the use of collateral.
ISDA (the International Swap and Derivatives Association) have encouraged the perception that the unwinding of derivative contracts necessitated by the Chapter 11 filing by Lehman was largely untroubled, with contracts settling much as expected. In July 2010, ISDA wrote that: “counterparties were able to close out their over-the-counter (OTC) trades smoothly under…’master agreement’, despite severely stressed market conditions.” As Demosthenes, a Greek statesman, observed: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”
The reality, perhaps unsurprisingly, is more complex and not entirely consistent with this soothing narrative.
Who’s the Master?
Derivative transactions are documented using the ISDA Master Agreement. The Master Agreement sets up a framework under which individual transactions are documented in the form of relatively short confirmations detailing the economics and cash flows of specific transactions. ISDA’s remarkable achievement has been to standardise documentation with increasingly all trading instruments being documented under the ISDA Master Agreement framework.
The original idea was that the bulk of trading between institutions would be governed by a single master agreement facilitating management of the contracts. In practice, this has proved difficult because of the complex legal structure and operations of individual institutions. In practice, there may be multiple masters between institutions.
There are also two versions of the ISDA Master – the 1992 or 2002 edition. There are important differences between the two contracts, notably in relation to determination of loss upon termination. Increasingly, outstanding transactions are governed by a combination of the two versions of the contract.
While the Master Agreement has been in widespread use in financial markets for over 20 years, there have been relatively few defaults and there is limited case law on the interpretation of crucial elements of the contracts.
Breaking Up is Hard to Do…
Where one or other party defaults, for example due to bankruptcy, the basic operation of the contracts should be as follows:
1. All contracts should terminate, triggering unwinding of all open transactions governed by the Master Agreement.
2. The value of each transaction must be determined.
3. Amounts owing or owed on individual transactions should be netted off to arrive at an aggregate sum that is owed by one party to the other (known as “Close-out Netting”).
4. Any net amount owing should be paid. In case of a bankruptcy, this means that if an amount is owed to the bankrupt party then the amount is paid to the bankruptcy trustee or administrator. If an amount is owed by the bankrupt party, then that amount will rank as a debt to be paid out of recoveries.
The economic logic underlying the mechanics is that the non-defaulting party can close out its open positions at market rates. It can then enter new transactions in the market to establish replacement hedges to avoid risk of loss from potential changes in prices or rates. In practice, there are a number of difficulties.
Where there is an event of default affecting one party (non-payment, breach of agreement, bankruptcy etc), the contract technically is capable of termination. However, there are two termination structures. In the first, the non-defaulting party can by notice terminate the contract. In the second, where automatic early termination (“AET”) is selected, the contracts terminate without the need for any action.
In practice, both voluntary termination and AET are used. Where AET is selected, the termination removes the non-defaulting party’s choice. This means that it can be forced to close out positions even when it may be disadvantageous to its own economic interest. The non-defaulting party may also be unable to re-hedge on a timely basis or at price levels used to calculate termination values.
Valuation of contracts upon termination due to default by one party can be problematic. The 1992 Master Agreement requires parties to use either “Market Quotations” or the “Loss” method.
“Market Quotation'” requires obtaining market valuations of the obligation which the Non-defaulting Party has lost as a result of the default. This is done by obtaining quotations for replacing the Defaulting Party in the transaction from a representative number of market makers. The definition and required mechanics are complex and not easy to implement, especially in volatile market conditions. If “Market Quotations” cannot be obtained or where this method has not be selected, the “Loss” method must be used.
“Loss” is defined as: “Loss means, with respect……………and a party,………….an amount that party reasonably determines in good faith to be its total losses and costs (or gains, in which case expressed as a negative number) in connection with the ISDA Master or the terminated swap transaction or a group of terminated transactions, as the case may be, including any loss of bargain, costs of funding or, at the election of such party but without duplication, loss or costs incurred as a result of terminating, liquidating, obtaining or re-establishing any hedge or related trading position…” There is little case law on interpretation of the “Loss” definition.
In the 2002 Master Agreement, a new measure “Close-out Amount” replaces the “Market Quotations” or “Loss” method. The “Close-Out Amount” is the losses or costs of replacing or providing from the economic equivalent of the terminated transactions. The new provision is more flexible than the earlier formulation encompassing market quotations, model-based valuations or other methods, which are “commercially reasonable.”
A key problem is that the structure of the documentation evolved around simpler derivatives such as interest rate and currency swaps. The application of the prescribed methodology to more complex and newer instruments, such as credit derivatives and other exotic structures, is largely untested.
Valuation presents numerous mechanical challenges such as the exact timing of the valuation, presentation of the calculation statement and also the calculation agent who carries out the required procedures. The agreement allows the agent to calculate loss “in good faith” taking into account all the relevant facts of the matter.
The Master Agreement establishes procedures for the appointment of a calculation agent to make the determination of value and the payments to be made on the contract. In many cases, the designated calculation agent in the agreement is the dealer. In an instance such as Lehman where the dealer is the defaulting party, this can lead to problems and conflicts of interest.
Once contract values have been established, the amounts payable or receivable must be netted to establish the net settlement amount. This assumes that the Closeout Netting contracts provisions operate as intended. It is not clear that the netting provisions will be enforceable in the case of the insolvency of one party in every jurisdiction, notwithstanding expensive and heavily qualified legal opinions. Irrespective of the governing law selected (usually English or New York), the ultimate enforceability of netting provisions depends upon the law in the jurisdiction in which it is incorporated, in particular, the applicable insolvency law.
If the closeout netting provisions are ineffective, then there is the risk of “cherry picking” upon insolvency. This allows liquidators and bankruptcy trustees to selectively enforce and disclaim transactions. In practice, this would mean that liquidators seek to enforce all transactions whose termination would entail the bankrupt entity being owed money.
The legal operation of the contract assumes that the underlying market continues to be functional. In practice, this means that the market trades normally, allowing the non-defaulting party to re-hedge positions and establish valuations with reasonable accuracy. When Lehman filed for bankruptcy protection, swap counterparties were unable to replace hedges in a reasonable time period. In many cases, where hedges were established, there were differences between the cost incurred and the termination values under the ISDA settlement mechanism. This resulted in counterparties experiencing significant losses.
Oscar Wilde famously observed: “To expect the unexpected shows a thoroughly modern intellect.” Despite the modern nature of their instrument, derivative professionals were curiously old fashioned, expecting the market to work as they expected. They were to learn the veracity of Benjamin Disraeli’s comment: “What we anticipate seldom occurs: but what we least expect generally happens.”
The bankruptcy of Lehman illustrates the problems that occur when a dealer defaults.
Filing for Chapter 11 or its equivalent generally constitutes a termination event under the ISDA Master Agreements. In the Lehman case, not all legal entities simultaneously filed for bankruptcy. Due to operational and legal reasons, some group entities did not file at all and continued to operate or were ultimately purchased by other firms. This means that all derivative contracts were not capable of being terminated. Where entities filed for bankruptcy, there were differences in timing which created problems, especially in relation to determining termination values.
Even where contracts were eligible for termination, only where AET provisions had been agreed did the contracts automatically terminate. Where the non-defaulting party had the right to terminate, it is not clear whether all parties chose to terminate the contract. Alvarez & Marshal (“A&M”), the restructuring firm, managing the Lehman’s estate, has indicated that 85% of contracts terminated within one week.
Where AET provisions were not selected, the counterparty’s economic interests may favour continuation of the contract. For example, assume the counterparty sold protection under a credit default swap (“CDS”) to Lehman. Under the terms of the contract, Lehman’s is obligated to pay a periodic fee. The counterparty’s only obligation is to make a payment to Lehman if the nominated reference entity defaults. In effect, the contract functions in a manner analogous to credit insurance with the counterparty insuring Lehman from losses in case of default by the reference entity.
If the underlying reference entity is unlikely to default then the counterparty may be better off not terminating the contract. This is because it has no immediate performance obligations under the contract. If the reference entity does not default then the counterparty will never have to make any payment to Lehman.
However, if it terminates the contract then it may be obligated to pay Lehman based on the current market value of the contract. The market value of the contract, owing to Lehman, may be substantial where credit spreads in the market generally or related to the reference entity have increased. This is precisely what happened following Lehman filing for bankruptcy protection. Not terminating the contracts avoids the need to make this payment.
Similar considerations would apply to other derivative contracts, especially where the counterparty had sold options to Lehman. The increase in volatility following the Lehman Chapter 11 filing led to significant mark-to-market losses that would be owing to Lehman if the contracts were terminated.
Where contracts are terminated, the Master Agreement requires a calculation statement to be served setting out the amounts payable or owing. This requires the termination value as of the relevant date to be determined.
In the Lehman case, termination values proved problematic. Following the filing, market quotations were not available, especially in the case of more complex and difficult to value products. Even where available, there were significant differences in valuations for some transactions. The turbulent market conditions, ironically caused by the Lehman filing, exacerbated the difficulties. Differences in and confusion about termination dates compounded problems and may have contributed to substantial differences in valuation of contracts.
At the time of its filing, Lehman had around 1,200,000 derivative contracts with notional face value of around $39 trillion open. As at September 2009, a court imposed deadline, around 6,000 derivatives claims totaling $60 billion payable by Lehman was filed against the US estate, including claims from 40 of the largest US banks.
The problems were compounded by operational problems. Market participants who dealt with various Lehman entities had multiple ISDA master agreements in place with different transactions recorded under each contract. Many counterparty’s information systems inaccurately grouped contracts for the purposes of netting and determining net exposure, making it difficult to determine risks and hedging actions needed.
Determination of termination values and net amounts owing and payable were complicated by the fact that valuations for all transactions governed by a single Master Agreement were necessary. In practice, this was not easy creating problems in issuing calculation statements and settling open positions. In effect, a single contract could potentially contaminate the entire ISDA master and pose difficulties.
The problems experienced are evidenced by two cases.
Metavante had entered into a $600 million interest rate swap with Lehman Brothers Special Financing (“LBSF”), a Lehman entity, under which Metavante paid 3.865% p.a. to LBSF and received 3 month LIBOR from LBSF.
After Lehman filed for Chapter 11, Metavante was entitled to but did not terminate the swap. While the swap remained operational, Metavante refused to make payments as required by the contract. As interest rates had fallen sharply, Metavante was obliged to pay LBSF the difference between 3.865% and lower 3 month LIBOR rates. Had the contract been terminated, Metavante would have owed a sum in excess of $6 million to LBSF. It appeared that Metavante was hoping that interest rates would rise lowering the cost of terminating the swap. The court ruled against Metavante and the matter was settled by mutual agreement.
In April 2010, Lehman brought legal action in relation derivative contract against three separate Nomura entities – Nomura International, Nomura Securities and Nomura Global Financial Products. The suit alleged that the Japanese bank was not entitled to recover a claim of over $1 billion but instead it owed Lehman a substantial amount.
The dispute centers on 4,368 derivative transactions between the companies governed by ISDA master agreements. When Lehman filed for Chapter 11, the ISDA master agreement between the parties terminated under the AET provisions agreed to between the parties. Prior to termination as of 8 September 2008, it appears that the value of the contracts was $484 million in favour of Lehman. Under credit support arrangements in place, Nomura transferred collateral to Lehman reflecting this value.
After the filing, Nomura lodged a calculation statement claiming that Lehman owed it $217 million. The change of $700 million in valuation, Lehman alleges, was the result of changes in Nomura’s methodology. Nomura was unable it appears to obtain market quotations and relied on the loss method.
Subsequently, Nomura served a second calculation statement in respect of one of the entities that increased the amount it was owed by $270 million. This reflected the impact of transactions related to Icelandic banks that defaulted in November 2008, two months after the agreement between the parties supposedly ended.
Lehman claims that Nomura inflated its derivatives losses by “hundreds of millions of dollars” using “egregious” valuations which were “commercially unreasonable, divorced from economic reality, and bear no relation to any actual damages or losses suffered by Nomura”. The calculation was merely an attempt by Nomura to wrongfully “secure a windfall” from Lehman’s bankruptcy at the expense of creditors. Nomura rejected the allegations.
Lehman is seeking a ruling that Nomura improperly calculated the amounts owing under the ISDA master agreement. It is also seeking judgment against Nomura to pay the bankrupt estate the amount owed to Lehman on the terminated swaps. The dispute is scheduled to come to trial sometime in 2011, unless settled.
The Metavante and especially the Nomura dispute highlight the problems encountered in terminating open derivative positions and the settlement framework. In a July 2009 interview on CNBC, A&M’s Bryan Marsal, CEO of Lehman, commented that “the market quotation system causes issues”.
Lehman’s financial statements and court filings attest the difficulties encountered in the recovery of derivative receivables. Lehman’ Financial Statements of November 2009 note that:
Recoveries in respect of derivatives receivables are complicated by numerous and unprecedented practical and legal challenges, including:
whether counterparties have validly declared termination dates in respect of derivatives and lack of clarity as to the exact date and time as of when counterparties ascribed values to their derivatives contracts;
abnormally wide bid-offer spreads and extreme liquidity adjustments resulting from market conditions in effect as of the time when the vast majority of the Company’s derivatives transactions were terminated and whether such market conditions provide the Company with a basis for invalidating counterparty valuations;
counterparty creditworthiness, which can be reflected both in reduced actual cash collections from counterparties and in reduced valuations ascribed by the market to such counterparties’ derivatives transactions and whether, in the latter circumstance, such reduced valuations are legally valid deductions from the fair value of derivatives receivables; and
legal provisions in derivatives contracts that purport to penalize the defaulting party by way of close-out and valuation mechanics, suspended payments, structural subordination in relation to transactions with certain special purpose vehicles, deductions for financial advisory and legal fees that the Company believes are excessive and expansive set-off provisions.
According to its own valuations, Lehman’s claim that the day before the bankruptcy filing the firm was actually owed money from counterparties on its open derivative positions. However, following the bankruptcy filling, the banks filed claims for a total of $51 billion.
Marsal has been outspoken on the issue, accusing major banks of “bankruptcy opportunism”, seeking to make “windfall profits” by making large claims. A&M and Lehman have begun to press banks in an attempt to reduce claims against the estate by a process of “naming and shaming”. Marsal told the Financial Times that
We have ranked all the banks according to their claims from the worst actors to the best actors. Starting in March, we will begin to challenge their claims with our supporting data. If we do not settle, they will have to go to court and prove their claims.
The Nomura litigation should be seen in this context as a negotiating strategy to ratchet up the pressure on banks.
Marsal and A&M believe that many claims are exaggerated, with banks using model to calculate the “theoretical loss in a market that has no bearing on reality” permitting “extremism” in the calculation of the value of the claims. The banks argue that the claims represent the “true” cost of replacing the defaulted Lehman trades in the market. Given the latitude and broad discretion in calculating the termination value under the “loss method” embedded in the documentation, it is unclear whether A&M’s view is consistent with the ISDA master agreement provisions or sustainable at law.
In order to short circuit the lengthy process of resolving derivative claims and the risk of time consuming, expensive litigation, A&M have proposed a ‘resolution scheme’. If accepted by the dealer, then the arrangement would apply to all derivatives claims involving bankrupt Lehman entities and resolve them in an integrated settlement. The key driver of the scheme, at least from Lehman/ A&M’s perspective, appears to be the resultant reduction in claims from around $40 billion to around $30-35 billion.
The scheme proposes standardised valuation methodologies that would be applied all transactions. The process would vitiate the need for the contract-by-contract process prescribed by the ISDA Master.
There are significant problems with the proposed methodologies. While there may be agreement on standard models for conventional derivatives, it is not clear whether it will be feasible to agree models and approaches for more exotic structures.
One interesting issue is the risk of counterparty credit risk and the extent to which this should be factored into the valuation. Subsequent to and in response to the global financial crisis, there have been significant changes in the way cash flows are discounted back over time in derivative transactions. Prior to the crisis, it was commonplace to discount back cash flows at the swap rate, which provided a reasonable proxy for the cost of funding for major banks around the world active as derivative traders. The sharp and significant differences in the funding costs of individual banks during and following the crisis have resulted in changes in models. A complicating factor is the use of collateralisation arrangements to enhance the credit of counterparty.
The current trend is to for dealers to discount future cash flows in uncollateralised trades at the rate at which each bank can borrow. For collateralised trades, cash flows are discounted at the relevant overnight index swap (OIS) rate. Unfortunately, there is no agreement between dealers on specific aspects of the models.
For example, a US dollar transaction that stipulates the posting of dollar cash collateral should be discounted using the federal funds rate. But this becomes complex where the trade is backed by a variety of different collateral, involving a variety of credit risks, currencies and trading liquidity. While dealers agree the discount rate should in theory be based on the cheapest-to-deliver collateral, it is near impossible to determine what specific security this might be over the entire life of the transaction. It is not clear how these issues affect the valuation of the terminated Lehman transactions.
Even if agreement can be reached on the models, there are likely to be significant differences in opinion about prices and rates that are inputs into these models. The Lehman/ A&M proposal uses the end-of-day mid-market price on an agreed termination date (likely to be 15 September 15 2008) to value the open transactions. Dealers have rejected this approach, arguing that individual dealers may have closed out trades at different times varying from the fixed termination date and that market prices were very volatile at the relevant period.
The differences in model and inputs would result in valuation differences of hundreds of millions of dollars for individual dealers.
The Lehman/ A&M plan must be agreed with individual counterparties, under the existing ISDA documentation. Lehman/ A&M are seeking to reach agreement with major derivative dealers, that hold approximately 48% of the total claims, with the objective of then imposing the methodology universally.
The proposal has, to date, been opposed by most of the banks, on the basis that the framework is simplistic and inflexible. In any case, even if the major dealers agree, it is not clear how Lehman/ A&M can force other banks to accept the approach.
The ongoing soap opera surrounding the Lehman derivative contracts highlights the lack of certainty of settling derivatives contracts post default and the complex documentary issues that remain unresolved.
The aftermath of the Lehman filing illustrated Yogi Berra’s famous observation: “In theory, there is no difference between theory and practice. But, in practice, there is.”