CalPERS Takes on Risk Where Federal Government Fears to Tread: Provides Liquidity to a Derivatives Central Counterparty on the Cheap

As we’ll unpack below, CalPERS has engaged in one of the most bone-headed moves I can recall reading about, the financial equivalent of trying to pick up pennies before a steamroller.

The giant California pension fund has signed up to take on systemic risk at a bargain basement price, by providing liquidity support to one of the central counterparties for over-the-counter derivatives, the Options Clearing Corporation. This is a flagrant violation of any sensible notion of risk management. As derivatives expert Satyajit Das, who has written extensively about central counterparties, said via e-mail: “Why would you want to take the risk of having to finance or recapitalise an entity at precisely the moment when they are in trouble, especially when the compensation is inadequate?”

Yet this is precisely what CalPERS has agreed to do. From Pensions & Investments:

CalPERS this month renewed its agreement to participate in a fully committed repurchase facility with derivatives clearinghouse Options Clearing Corp. and securities lending agent eSecLending.

The $278.4 billion California Public Employees’ Retirement System, Sacramento, will provide contingency liquidity in the event of a counterparty default, under terms of the repurchase facility to which it originally agreed last year. eSecLending serves as the agent for CalPERS.

The renewal is staggered, said Angela Kotso, spokeswoman at Chicago-based OCC, with a $500 million tranche for six months effective through June 30. Then, Ms. Kotso said, the tranche will become a one-year facility.

The other $500 million tranche is for one year ending in January 2017, Ms. Kotso said.

Overall, OCC requires $3 billion in liquidity needed to cover all its counterparty defaults; the CalPERS facility covers $1 billion, with the remaining $2 billion covered by banks, said John Fennell, executive vice president of financial risk management at OCC.

Yves here. I have not been able to confirm it, but given the concentration among derivative dealers and the widespread description of how counterparty clearing houses work, it seems likely that most if not all of the banks providing liquidity backstops are clearing customers/counterparties to the central counterparty. And having them backstop the central counterparty was part of the design: One of the ways central counterparties were supposed to reduce risk was by syndicating the risk of the failure of a particular counterparty among the owner/sponsors of the central counterparty, who would have arranged to provide it with support…up to a point. So most if not all of the banks that are part of providing liquidity support probably would have had at least some of their part of that $2 billion exposure regardless.

And that is where the concern comes in. Everyone who has looked at central counterparties in a serious way observes that they concentrate risk, and create too big to fail entities when the support buffers are breached. The tacit and sometimes explicit assumption of all commentators, despite the officialdom’s desire to pretend otherwise, is that the government would be required to prevent a central counterparty failure. As Das observed:

Anyone who thinks that a CCP cannot fails is living in ‘la-la land’. The consequences of such a collapse would be worse than Lehman.

It’s thus insane for CalPERS to sign up to be the first line of defense for this type of risk, particularly, as we wrote earlier this week, the Office for Financial Research has put central counterparty failure as one of the three biggest current systemic risks, and John Dizard of the Financial Times separately reported that large banks have been pressing financial regulators to force the central counterparties to hold more capital, meaning they believe that they are undercapitalized, yet the authorities have said they are doing nothing till after the 2016 elections. So this risk is not theoretical. CalPERS is standing ready to take a bullet when this type of entity* is being widely depicted as an unsound risk.

CalPERS is already long systemic risk by being an investor which is taking on a lot of beta (market risk) by having both a high level of equity risk in its portfolio (51% target) and a goal of roughly 10% to levered equities, in the form of private equity. So it has already put itself in the position of being whacked hard in the event of a financial crisis, in which risky assets all move together, as in down (in risk-manager speak, all correlations move to one).

CalPERS found itself over-exposed in the last crisis. It was hit by capital calls by private equity fund managers even though it had begged them not to make them (I’ve spoken to private equity firm staffers who recall getting the CalPERS missives asking them not to make capitals calls and ignored them, since the general partners had a clear contractual right to demand funds). CalPERS was liquidity-constrained when those capital calls came in and had to dump stocks. And to make a bad picture worse, it had lent out stocks under its securites lending program and could not get enough of them back, and those were generally big cap, liquid issues. As a result, it wound up selling less liquid stocks, making the losses it suffered even worse than they would have been otherwise.

CalPERS would contend that is has wised up, as evidenced by the fact that its current securities lending program is considerably smaller than its pre-crisis one. But it has taken on other “go long systemic risk” bets like its credit line to the Options Clearing Corporation. And as we’ll discuss in a future post, not only does it remain exposed to private equity capital calls at adverse times, but private equity firms have been asking funds like CalPERS to provide credit lines at the fund level (borrowing has historically taken place at the investee company level, so investors like CalPERS historically had no exposure beyond their commitment amount). These credit lines, like the Options Clearing Corporation credit line, are most likely to be used in a big way at the worst moment, when other sources of funds have dried up.

This is the sort of risk management move that Nassim Nicholas Taleb would inveigh against. Mathematician Benoit Mandelbrot, who is one of Taleb’s touchstones, found that standard finance theories underestimate market risk on several important dimensions, the biggest resulting from the fact that models that fit the actual risk of markets are not mathematically tractable. Their randomness is too wild, so risk metrics have substituted a safer world to look at than the one that really exists. As we and others discussed at length before, during, and after the crisis, the prevailing models (and even most of the improved versions) do a good job of with day to day risk, but greatly underestimate “tail” risk, that of extreme events. Just look at oil prices as an example. No one would have guessed when the Saudis refused to cut production to maintain oil prices that they would drop to below $30 a barrel and remain depressed as long as they have.

Let’s turn to the specifics. Readers may recall that at the beginning of the week, we discussed the risk posed by central counterparties, also called central clearinghouses, which are now the venue for clearing a large majority of over-the-counter derivatives. The idea behind the central counterparties was to reduce market risk by reducing the number of bi-lateral exposures and by making risk management more transparent.

However, as much as this change was beneficial, a big problem is that the move to central counterparties was intended to reduce systemic risk. In fact, if you subscribe to the observations of Richard Bookstaber, the author of the book A Demon of Our Design, about risk management, the most important risk reduction move in any tightly-coupled system (one that is overly prone to spin out of control because it is overly interconnected) is to reduce the tight coupling, as in reduce the overconnectedness. We’ve long argued that the first step needs to be a deliberate effort to cut down on the amount of over-the-counter derivatives. That is one of the major, and arguably the biggest, vector of tight coupling. Bookstaber warns that in a tightly coupled system, efforts to reduce risk typically wind up increasing it.

Another issue with the central counterparties is that their bigger function, sadly, is to create the impression that they’ve eliminated a big chunk of “too big to fail” risk. In other words, their political importance in terms of perceived (or pretended) risk reduction is almost certainly greater than the actual risk reduction that could have taken place. And mind you, “could have taken place” assumes perfect implementation. This idea has not been perfectly implemented. Contracts have not been standardized, multiple counterparties compete with each other, creating “race to the bottom” incentives, and the counterparties are profit-making entites, which creates conflicts with their owner/sponsors (banks and big customers), when the theory was that their risks were supposed to be aligned.

Izabella Kaminska of FT Alphaville this week flagged yet another not-widely-recognized risk of central counterparties: that real-time gross settlement systems, which are billed as reducing risk, when in fact they merely reduce risk to banks and increase them overall, ane worse, drive them into the shadow banking system, where it is harder for central banks to pump in emergency money when a crisis hits. I find that her article is unnecessarily convoluted in trying to split hairs between liquidity risk and credit risk. That’s a meaningful distinction when you are talking about longer-term exposures when the lender with a dud credit can make it look viable by various forms of accounting fakery (as in missed or late payments don’t create any meaningful liquidity pressures). By contrast, with settlements happening in mere days, a credit problem pretty immediately becomes a liquidity problem.

The bigger implication of her piece is thus: real time gross settlement effectively compresses settlement times. That’s what real time means. Accelerated settlement times place more stringent demands on everyone. That makes the process fault intolerant and thus increases the risk of counterparty failure, contrary to pretenses or intentions otherwise.

Taleb recommends the exact opposite strategy to the one CalPERS is taking: take out cheap (as in out of the money) wagers on extreme bad stuff happening. You lose most of the time, but you lose small amounts, and you get the occasional very large payoff. CalPERS is too large and inherently net long to do that on any scale, but it should be trying to implement a Taleb-like strategy, even an a small way, to offset its native exposure to Really Bad Things Happening, rather than doubling down on that type of risk.

* There is no reason to think that Options Clearing Corporation is any better than any other central counterparty, and no reason to think that CalPERS would have the ability to pick a counterparty that was less risky than others.

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  1. ArkansasAngie

    No worries … the fix is in.

    There is no counter party risk.

    TBTF is alive and well.

    This is free money … don’t you know

    1. Yves Smith Post author

      No, no! You are missing the priority in payment! CalPERS will get hit first before the government runs in. Probably not to the full extent of its liquidity support, since drawing down credit lines in full is seen as really bad form (Bear didn’t do it and IIRC neither did AIG) But CalPERs is not systemically important, and the $2 billion across other banks at the OCC is eminently affordable (crikey, that’s a mere cost of doing business fine at a single big bank these days). Politically, it would be necessary, indeed required, for the backstops to be used in a serious way (and maybe in contrast to the old normal, in their entirely) before a TBTF rescue could occur.

  2. Steve H.

    A quick help-me-out here: is CalPERS risk limited to the $1 billion or is it no-limit? Is the problem confined, or is the problem a cascade effect from illiquidity?

    1. Yves Smith Post author

      They are only on the hook for $1 billion. But the issue is that $1 billion (or whatever amount it winds up being) will be called at the worst possible moment, when CalPERS is liquidity constrained and being hit on other fronts with demands. It had to dump hundreds of million of stock at depressed crisis prices last time to meet liquidity needs. It’s setting itself for the same kind of problem, albeit with a somewhat different mix of exposures.

      1. Thure

        Yeah, its pretty desperate stuff alright.

        Unless they have an extra $1b in the bank somewhere, which of course they don’t because they are trying to maximize returns, this amounts a naked futures contract facing a major margin call. Pretty dumb. considering they have no possible way of assessing the risk of upcoming counterparty failure.

        And to Yves’ point, if they start dumping positions they probably lose money on that side as well and could trigger both internal liquidity problems both for themselves as well as other firms because the whole market is completely over-leveraged and fundamentally unstable.

  3. Moneta

    The writing is on the wall, pension plan money will be used to finance the coming infra spending. In the mean time, these plan managers need to do something that seems to offer better than 2%.

    The discrepancy between zirp and pension return expectations is the source of the problem.

    As a society, we were deluded if we thought we could create and manage big pools of money without any raids over a 40-50 year time period.

    A bird in the hand is worth 2 in the bush. There is a reason why this proverb exists in all languages.

    1. Yves Smith Post author

      Absolutely correct, and I was remiss in not saying explicitly in the post that this trying to eke out some additional income by taking on tail risk was a sign of desperation about meeting return targets made unrealistic by ZIRP.

      1. Jim Haygood

        Missing from the linked article is how Calpers priced this deal. Like you, I presume that it’s a desperate attempt to cadge some crumbs of fee income for a commitment (so Calpers imagines) that will never be drawn down.

        Providing credit lines is what banks do, or used to do. As the article notes, ‘Regulatory requirements like Basel III make it more costly for banks to provide that liquidity.’

        But banks are members of the Federal Reserve and Calpers is not. If a political decision is taken to rescue a failed clearing house, exposed banks can be bailed out directly from the Fed. Calpers is another story.

        1. financial matters

          They might feel like they are due some special consideration.

          One example of the Feds emergency programs as a response to the crisis:

          TALF: The top three cumulative borrowers, Morgan Stanley, PIMCO, and California Public Employees’ Retirement System would borrow roughly $22 billion or 65 percent of the total borrowing. Together, they borrowed at a weighted average rate of 1.76 percent.

          1. Yves Smith Post author

            No, the TALF was not a “rescue important players” facility. It was a “hand out subsidies for people with money to cherry pick asset backed securities.” Even Morgan Stanley housewives were eligible, see Matt Tabbi The Real Housewives of Wall Street with the subhead, “Why is the Federal Reserve forking over $220 million in bailout money to the wives of two Morgan Stanley bigwigs?” From the story:

            This is where TALF fits into the bailout picture. Created just after Barack Obama’s election in November 2008, the program’s ostensible justification was to spur more consumer lending, which had dried up in the midst of the financial crisis. But instead of lending directly to car buyers and credit-card holders and students — that would have been socialism! — the Fed handed out a trillion dollars to banks and hedge funds, almost interest-free. In other words, the government lent taxpayer money to the same assholes who caused the crisis, so that they could then lend that money back out on the market virtually risk-free, at an enormous profit.

            Cue your Billy Mays voice, because wait, there’s more! A key aspect of TALF is that the Fed doles out the money through what are known as non-recourse loans. Essentially, this means that if you don’t pay the Fed back, it’s no big deal. The mechanism works like this: Hedge Fund Goon borrows, say, $100 million from the Fed to buy crappy loans, which are then transferred to the Fed as collateral. If Hedge Fund Goon decides not to repay that $100 million, the Fed simply keeps its pile of crappy securities and calls everything even.

            This is the deal of a lifetime. Think about it: You borrow millions, buy a bunch of crap securities and stash them on the Fed’s books. If the securities lose money, you leave them on the Fed’s lap and the public eats the loss. But if they make money, you take them back, cash them in and repay the funds you borrowed from the Fed. “Remember that crazy guy in the commercials who ran around covered in dollar bills shouting, ‘The government is giving out free money!’ ” says [Bill Black. “As crazy as he was, this is making it real.”

            So CalPERS was smart to hoover up as much TALF money as it could. But the TALF did not help CalPERS with its crisis liquidity crunch, nor did CalPERS get any access to rescue facilities that would have.

            1. financial matters

              This is what concerns me about the future.

              I think it’s important to try and block these various avenues that the Fed uses to support asset based securities and crappy loans.

  4. vlade

    I just do not see why calpers would to this, unless the pricing was so silly that it itsefl indicated something dodgy was going on.

    equity derivtives cpty is probably slightly less risky than others (there is a clear floor for downsid scenario, and on the upside problems are les likely and more manageable, as you don’t get the collateral/liquidity spiral), but that’s like saying that a bullet to the head is preferable to a death by drowning.

    the main issue is, as you say, that it’s impossible to price even vaguelly fairly. you are almost guaranteed to over or under priced, and correct pricing can happen only by a chnce (which is even more dangerous, as it makes you believe in your model).

    if you intentionally overprice, and the cpty accepts, you’d get supicious about what you missed.

    the only once scenrio I can see that is rational, is that the facility is a regultory arb. i.e. it cannot be prctically ever drawn, but it’s so hidden tht you can present it to the regultor/clients as ‘we have this bln facilityy from calpers’

    problem calpers has but refuses to recognise, is that it is about the size where averge long term return will converge to market beta. so instead of chasing return per se, they should concentrate on making it a cheap beta. of course, then it becomes hrd to justify your costs, or even existence.

  5. Chuck Roast

    So what!
    There is absolutely no liability here for the board members in the event of a catastrophic derivatives failure. Under the Prudent Man Rule they have will have met their fiduciary responsibility to the members as long as they didn’t demonstrably fall asleep at Board meetings. And unless it can be demonstrated that the Board’s staff were scoring nickles from the Fund’s Advisors…it’s all good!

  6. RUKidding

    Yikes! I’m an economics dummy and had to really furl my brow to grasp this recent maneuver by apparently feckless, reckless CalPers, but I think I grasp the gist of it.

    So playing fast and loose with $1billion NOW when a lot of signs – signs even obvious to me – point to a perhaps immanent market downtown, if not crash, plus once again the RE market is approaching bubble bubble toil and TROUBLE stage (knock, knock CalPers, just look out your windows at crazy Sacramento RE pricing right now)…

    As pointed out, US banks have some guarantee by FDIC. CalPers? Not so much.

    Great. I can see my pension, in the long run, going BUH-BYE! Thanks to maneuvers like these. Sheesh.

    Thanks as always Yves for these updates re CalPers. Good to know. The HR Mgr where I work just recently filled out some CalPers survey which was followed up by a phone interview seeking feedback on CalPers. Sadly, although our HR Mgr does a good job, this employee is totally out of the loop about CalPers long history of dodgy investment strategies. And they did ask for input about their investment strategies.

    My guess is that CalPers uses this “feedback” to inform them that their marks feel “good” about CalPers, which enables the Board to say: Way to go, Go, GO!!

    I’m trying to get info on how to call them to give them MY feedback. If that happens, will let you know.

  7. susan the other

    This is so unbelievable. Where are California regulations on this? This use of dedicated funds is a good harbinger of what would happen to SS if it were privatized. Are retirement funds the only pools of money left? And where are the derivatives to insure against CalPers potential losses? The whole thing is completely irrational. When it implodes there should be a stop gap that pays every party out over the next century at zirp. An annuity. That can be rolled over again in the 22nd century. In fact it could become the new universal retirement fund. jesus

    1. Moneta

      If they stick to traditional investments and asset allocation, return expectations will need to get cut as well as benefits….

      Stuck between a rock and a hard place…

  8. flora

    Let me see if I’ve got this right: CalPERS thinks it is going to decrease its financial risks in PE by financially backstopping those increasing wide systemic risks with its own money? What? I can’t be understanding this correctly.
    Appreciate the para on Taleb and Mandelbrot and the weak spots in math modeling, and on Kaminska’s flagging ‘accelerated settlement times’ increasing overall risk.

    Thank you very much for your reporting on CalPERS and PE.

  9. NoRiskTrader

    The OCC is different from other clearing houses. Whats troubling is the OCCs need of a credit line from a CALPERS? As touched on default by OCC means the investment banks themselves have defaulted. i.e a default of an option contract means the bank that provided margin to a client, itself did not pay as it was obligated to do. To be clear, its client didn’t respond to a margin call so that said stock(s) could be delivered, then the bank itself did not cover the obligation. The OCC’s system of Novation means their is a buyer for every seller and a seller for every buyer. If someone is assigned, they must deliver said stock(s). Default(?) means, not only didn’t clients deliver the stock(s) but their bank also did not. It is the bank itself that is the counterparty, not the customer,so how can a default occur? As Yves has indicated, that would mean that the banks themselves are insolvent, a systematic failure, i.e. that would mean that the banks themselves are insolvent. So CALPERS is betting that systemic failure will not occur. But why would the OCC need it? Why would the OCC need this additional line from a CALPERS in the first place? Why wasn’t their existing credit lines increased…since if said credit line was needed….it’s because the banks themselves had defaulted and created a crisis at the OCC. Does this infer that the banks are in trouble now since they didn’t increase the OCC’s credit lines? I recall during the so-called 2008 crisis,the banks could not lend against a SBLC. They wanted a deposit first..then wanted to lend you your own money. Again, why does the OCC need access to a credit line from a CALPERS or any other non-bank entity in the first place???

    1. Yves Smith Post author

      The Chicago Merc came within three minutes of failing in the 1987 crash. The story is told long form in David Mackenzie’s boos An Engine Not a Camera.

      The Merc was already fully into its credit lines when it was hit by another $400 million fail to pay. It called its relationship manager at its lead bank, Continental Illinois, and asked for an overdraft. The relationship officer said she didn’t have the authority. By sheer dint of luck, CEO Tom Theobald was in the office early. She was able to reach him and he agreed to approve the $400 million, which was a lot of money back then.

      What the book does not mention was at the time, Continental Illinois was in FDIC receivership. It had failed in 1984 and it took seven years for the FDIC to clean it up and sell pieces. It’s not clear to me that the CEO of a bank that was not on the government dime would have made the same decision then.

      The then-head of the NYSE, John Phelan, said that if the Merc had not opened, the NYSE would have not opened either, and he added it was not clear if the NYSE would have ever opened again if that had taken place.

    2. Yves Smith Post author

      Just to be sure, I also pinged Satyajit Das with your comment. This was his reply by e-mail:

      I am not sure what the reader is trying to say.
      The steps are as follows:

      1. Both parties post collateral (initial margin) and the contract is novated to the CCP.
      2. One party fails to meet variation margin. In theory, this means the CCP closes out the defaulted party positions and tries to replace in the market (which entail assumptions about trading liquidity). In theory, the initial margin should cover any loss if it is set properly which I doubt (15-20% on BBB CDS seems low to me). If the IM is insufficient then there is a capital cascade (which involves two things – recapitalising/ writing off shareholders’ funds and providing liquidity to enable the CCP to pay to replace the position).
      3. The reader is right in the following:

      a) the ban k(at least the clearing member banks) are the counterparty for the CCP. But if their clients don’t pay them or they have financial difficulties unrelated to CCP position, they will not be in a position to pay (in effect the clearing members are de factor guaranteeing their clients’ performance).
      b) Calpers is making a bet of systemic failure. CCP need the line to cover the point in 2.

  10. griffen

    This was an interesting read. I’m curios to know or understand, from a risk sharing perspective are they unable to parcel the $1 billion to other very large pension or endowment funds ?

    I don’t think a Yale or Harvard would do so, but just wondering aloud.

  11. Slade T

    This arrangement sounds completely inconsistent with calpers investment beliefs, perhaps some calpers execs are seeking jobs with the OCC?

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