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.