Perry Mehrling: Derivatives Remain a Blind Spot in the TBTF Debate

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Yves here. One of my pet peeves has been the way legislators and regulators have come up with various remedies to the Too Big to Fail problem, like living wills and Dodd Frank Article II resolutions, and have gone into Mission Accomplished mode. We’ve written lots of nitty-gritty posts debunking ideas like these when they were fresh.

As we stressed then, dealing with a problem like that of TBTF banks is like disarming a very large, live bomb. It has to be done carefully and in a certain order so as not to create lots of devastation. And as top risk manager Richard Bookstaber stressed in his book, A Demon of Our Design, the first step in reducing risk in a tightly-coupled system is to reduce the tight coupling. Implementing any other type of risk reduction effort will make matters worse. We’ve identified derivatives as the biggest source of tight coupling, which means it needs to be given top priority in “end TBTF” efforts, and needs to be addressed in a informed manner.

This very readable post by Perry Mehring illustrates that the officialdom still has a very long way to go. While they’ve at least included some aspects of derivatives risk in their efforts (like moving many to central clearinghouses), Mehrling exposes the glaring problems in one element of the plan to deal with derivatives that banks intermediate.

And Merhling makes a key point: that too much of the thinking about TBTF focuses on solvency of individual institutions. In a system of market-based credit, the authorities feel they must keep financial markets operating. Bear was not bailed out because it was a systemically important institution by virtue of size. It was seen as too important to let fail because it was a critically important player in the credit default swaps market by virtue of being the number three prime broker. Money market funds were rescues not to protect the funds themselves, but because they were a major source of funding in the repo market, which was and remains an critical source of liquidity to the major capital markets trading firms. Similarly, the Administration’s considerable efforts to paper over chain of title issues in the mortgage-backed securities market weren’t to save Bank of America, which was heavily exposed due to its acquisition of Countrywide. It was because it perceived the MBS market to be too big to fail.

BY Perry Mehrling, a professor of economics at Barnard College. Originally published at his website

The word has come down, “Never again!”

On October 14, 2008, the US Treasury announced a plan to recapitalize the US banking system, to the tune of $250 billion, starting with the nine biggest banks who were forced to take the money, whether they wanted to or not.  The government got its (our) money back, but that’s not what matters.  Private risk-taking for private profit on the upside seems to require private risk-taking for private loss on the downside.  And implementation of that principle has been taken to require very substantially increased total loss absorbing capacity (TLAC), starting with larger regulatory capital buffers but including also a second tranche of supplementary capital in the form of “bailin-able” bonds that can be converted to equity in times of stress.

That’s the state of play at the moment.  Sounds good, right?

The problem is that derivative contracts, written under the standard ISDA master agreement, give non-defaulting counterparties the right to immediate termination, which in effect puts them at the front of the line relative to other creditors.  Just so, when Lehman filed for bankruptcy, their derivative counterparties terminated their exposure, often on terms disadvantageous to Lehman (and hence to Lehman’s other creditors).  Just so, a marginally solvent firm became deeply insolvent.  Having this experience in mind, regulators want to make sure that the enhanced TLAC is not simply absorbed by this kind of front-of-the-line contract termination, leaving nothing for the other creditors and hence requiring government backstop to ensure ongoing operation.

To prevent this, regulators have come up with something called the ISDA Stay Protocol which they have pressured the major dealer banks to sign.  Under this protocol, termination rights are delayed by 48 hours.  The idea is that this should be enough time to arrange for the (private) recapitalization of a failing bank, which will then present the non-defaulting counterparties with a new healthy counterparty, and so eliminate the need for termination.  The idea is to keep the entire book of derivative exposures alive for two days while a bridge is built to transfer that book from the old counterparty to the new one.

Sounds good, right?

The problem is that hedge funds, and others who see themselves losing a valuable termination right, are reluctant to sign the protocol, and they have good reasons to be reluctant.

From their point of view, the whole point of the termination right is to enable the non-defaulting counterparty to find their own new counterparty, immediately.  If your hedge has just disappeared, you need to find a new hedge, ASAP.  Two days of limbo, during which you are supposed to trust a new untested resolution process, and after which you will be presented with a new counterparty chosen by someone else, is a very different matter.  Most obviously, two days in a stressed market situation is forever.  Prices can move, and you can be required to make very large payments, all the while your hedge is frozen in the resolution process; now it is your capital on the line.  In effect, what the regulators seem to have in mind is recruiting derivative counterparty capital as a third line of defense.  No thanks.

From a money view perspective, what is most troubling about this entire debate, on both sides, is the unrelenting emphasis on solvency, not liquidity, and the consequent (inadvertent?) implicit assumption of efficient markets.

Price is not necessarily always equal to value, and market pressure on either sell or buy side can push price pretty far from value.  (Don’t trust me on this, listen to Fischer Black.)  This is the central message of modern models of the economics of the dealer function.  Dealers make money by absorbing imbalances in market demand on their own balance sheet, buying below value when everyone is selling, and selling above value when everyone is buying.  Dealers do these trades because they expect them to be profitable when, in course of time, they are able to reverse them.

But dealers have in mind always that, in order to reap that profit, they need to be able to survive the course of time.  Forty eight hours can be too long.  In times of stress, even stress that involves only an individual market or individual counterparty, profit-motivated dealers will be less willing to supply liquidity to the market.  As a result, price can be expected to deviate much farther from value than in normal times.  Traders know that, and can be depended on to protect themselves ex ante by stepping away from counterparties at the very first sign of trouble, or by finding other trading and clearing venues.

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  1. craazyboy

    I guess I’m very much opposed to “two days = forever”, since I plan to live forever and want that to be longer than two days.

  2. Chauncey Gardiner

    As Senator Warren has repeatedly called for, this article again points out the need to break up the TBTFs and separate their speculative proprietary trading activities from basic banking functions, including their huge speculative derivatives bets, as the nation had before the Glass-Steagall Act was effectively repealed.

    Reading another article about the risk posed to the nation’s (and global) financial system by these huge derivatives bets, which now reportedly total several hundred trillion dollars according to the Bank for International Settlements, is a little like hearing the truth repeatedly on an old scratched 78RPM vinyl phonograph record.

    Given time and latitude, these clowns will again blow up the financial system.

    My question is whether they have embedded provisions in the “financial services” sections of the secret TPP, TTIP and TISA “trade” agreements to try to prevent necessary systemic changes and again force us to bail them out.

    1. James Levy

      What boggles my mind, and what I’ve never gotten a remotely satisfactory answer to, is the question, in a global economy whose yearly production of goods and services may be $100 trillion dollars, how and why do hundreds of trillions of dollars worth of derivatives exist? What purpose can they possibly serve that any government would countenance? How do Economist pretend that me saying, in effect, that I just took out a $20 million dollar loan on my $875,000 home is just dandy? No one seems willing or able to ask fundamental questions about this activity–everyone seems to just take this insanity as a given and then argue around the margins.

  3. susan the other

    Great essay. Thank you. My sentences are exploding and I’m not gonna get them out except for these. We definitely need a new way to insure liquidity. By insuring all hedges so banks can provide liquidity and not risk the thing they use to do it, so by giving them instant compensation, before any other creditor, is nutty because it turns money into a commodity. Just the opposite of what derivatives were invented to smooth out. Where hedging and derivatives were first used to insure farmers a contract price, it has morphed into insuring money itself as a contract price. But money has never been and should never be a commodity. Gold is a commodity. If hedgies put up gold for their side of the bargain – then maybe they could reasonable demand a first and instantaneous position before the price of gold crashes because gold is just another commodity. Money is not a commodity. Money is just a means of exchange.

    1. OpenThePodBayDoorsHAL

      Thanks for this informed comment. We are told that the derivatives risk is notional and will “net out”, but that’s exactly what did not happen in 2008, in a crisis it’s every man for himself and the chain of collateral breaks. At 9/11 the chairman of BONY rang up Sandy Weill and asked him for a cool billion, over the counter so to speak, so he could close the books that evening. In the next leg of this crisis, who are they gonna call? The Central Bank of Mars?
      In Egypt between Tut and Cleopatra was a period of hundreds of years “when all trade stopped because the money system got broken”. I think that’s what we’re in for.
      And you can’t hide in gold, at least if your goal is to protect a dollar value of assets. In the depth of crisis they turn to hard money, gold repos, and that boost in the supply of “paper gold” clobbers the dollar price.
      So maybe it is “canned food and ammo” time.

  4. Anon

    Now that the protocol has been drafted, surely the next step is to integrate it into the contracts.

    The fact that derivative contracts were given super-seniority (for the most part in the 2005 Bankruptcy Act — prior exceptions were drawn much more narrowly and Master Agreements weren’t covered) was an mistake that the regulators are slowly working on rolling back. Needless to say the financial industry is making sure the process is as slow as possible.

    So I don’t get Mehrling’s concerns. The economy has functioned fine for centuries without these special privileges for derivatives. Why do we need to preserve such special privileges for the financial sector now?

  5. Jim

    “In a system of market-based credit the authorities feel that they must keep financial markets operating.”

    Does NC feel the same way?

    If so, why?

  6. Blurtman

    Western banks need to be competitive and able to engage in every possible sleazy activity to stay competitive on the world stage. It is a matter of national security.

  7. alex morfesis

    17.5 billion

    the answer is quite simple…FDIC insurance is reduced to only 17.5 billion dollars of deposits…

    I am sure the world trusts Jimmy deamond at JP Morganite/morganatic to manage those few trillion dollars in assets without taxpayer backstops…

    maybe they can get charlie munger to write up some “deposit insurance” policies thru GenRe for those really solid and trustworthy enterprises…because, why should they have to worry about some stinkin regulations…

    regulations…we don’t need no stinking regulations…we don’t need to show you no stinkin regulations…

    teaPP anyone…???

  8. Russell Scott Day/Transcendia (tm)

    Geneen, long ago, ITT, one of the CEO Accountants if I remember from so far back, Said: “It’s not how much money you have, but how much you have access to.”
    These Derivatives ought not be insured. Nor do I think the Credit Default Swaps ought be insured.
    Every US Citizen became the Reinsurer of AIG. Whatever the Insurance Company is being begged to insure that the Insurance Company goes ahead and insures counting on the US Citizens to be the reinsurers of needs to be exposed now since this was were all of it fell apart from.
    And another thing. The smart guys, and there are too many of them, take for granted the Reserve Currency Status of the Petrodollar. That Petrodollar was trusted for more than just what is written on it. Internally the businesses of the US, in the US, in themselves and as other companies orbited around their needs made that dollar strong.
    The dividing and selling of parts of companies to make it look like there is more when there is less, less of that real strength is becoming understood.
    The DuPonts led in abandoning business for finance. I’d not be surprised to find their money, whatever is left of it looking for solid businesses.
    Meltox and companies like that that the Kochs own are not finance, but all these essential little things inside things make them so much money they play politics.
    Between Politics and Publishing you can really lose money, but there you go. What is worth insuring is worth having.
    What isn’t ought not be.

  9. High-Heeled T-Strap Sandals

    Think about Julie and volume blessing just book ‘party plane’ | Delta | Angelina – Jolie | _ Sina fashion _ShoppingNike planeLead: Delta to compete for the entertainment industry, tourism business, launched the ‘party plane’, carefully selected lucky passengers on the plane and have the opportunity to Angelina Jolie and other celebrities encounters and contacts. This part of the business valuation up to billions of dollars every year, oh. (Source: Network Interface Translator: Luo Dan Source: CF

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