1 December 2008

Global Financial System – Calling for the Plumber!

Satyajit Das November 24, 2008

Financial crises increasingly result from the structure of modern capital markets. External shocks – such as declines in housing prices – are transmitted via connections between participants who are tied together by complex chains of dealings. Concentration of trading amongst a small group of large dealers exacerbates the risk.

The decision not to support Lehman Brothers, with the benefit of hindsight, was a major miscalculation and a significant factor in the subsequent problems at AIG and other institutions as well as the complete failure of money markets.

Regulators and governments have shown limited appreciation of the detailed plumbing of the system for which they are responsible. In the present crisis, they have frequently appeared like Pritzker Prize winning architects trying to deal with blocked plumbing. Central bankers and finance ministers have found themselves in the position of Woody Allen: " Not only is there no god but try getting a plumber of weekends."

In fairness, even experienced professionals have struggled to understand the structure of modern markets. Jeremy Grantham, Chairman of GMO, recently observed: "I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. And I have no idea, really, how this will work out. I certainly wish it hadn’t happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."

Increasingly it is difficult to analyse the solvency of financial institutions. The speed with which available liquidity and access to funding can evaporate renders financial statements out-of-date and inadequate.

Agreements such as those governing derivative contracts also increasingly affect solvency. For example, the downgrade of AIG below a "AA" rating triggered margin calls (in excess of $10 billion). The downgrade also gave counterparties to transactions with the firm the right to terminate certain contracts triggering large losses ($4-5 billion). AIG did not have adequate resources to meet these commitments ultimately requiring US government support.

The exact effect of financial distress depends on the form of any restructuring. In the case of bankruptcy, Chapter 11 filing or equivalent, the crucial issue is which legal entities are placed under protection. In the case of Lehman Brothers, only selected entities (primarily the holding companies) filed while other entities continued to operate. This means that the position of each institution dealing with Lehmans may be different depending on which legal entity they contracted with.

In the case of Washington Mutual ("WaMu"), the Office of Thrift Supervision closed the bank on concerns about its ability to meet its obligations. J.P. Morgan subsequently paid $1.9 billion to the Federal Deposit Insurance Corporation ("FDIC"), in its capacity as receiver, for the assets and certain liabilities of Washington Mutual's banking operations. J.P.Morgan did not assume the senior unsecured debt, subordinated debt and preferred stock of WaMu resulting in losses for investors.

Financial distress inflicts predictable losses on creditors. In the case of Lehmans, creditors included banks from every continent – US, Europe, Japan, Asia and Australia. Retail investors in Asia and Europe who had purchased structured products issued by Lehmans also suffered losses.

Market estimates of recovery rates on Lehman’s debt are around 10-15% of face value (a loss to investors of 85-90%). Recovery rates will be affected by the nature of assets that many financial institutions now hold - private equity stakes, principal investments, hedge fund equity, complex slices of risk in structured finance transaction and derivatives. The difficulty in valuing these assets, their illiquidity and (currently) the absence of markets for many such assets may exacerbate losses.

If the financial institution files for Chapter 11 or bankruptcy then all derivative contracts entered into with the entity would also normally automatically terminate. This triggers a complex chain of events.

The value of the contracts must be determined by either seeking market quotations or other "commercially reasonable procedures" depending on the documentation. The values of individual contracts may be netted if the contracts specify to arrive at an overall amount that must be settled between the counterparty and the distressed entity. If the counterparty owes that amount then it must be paid immediately to the trustee in bankruptcy. This results in an immediate (possibly large) cash requirement for the non-defaulting party. If the distressed entity owes the amount then the counterparty must lodge proof of debt with the bankruptcy trustee and await payment.

If the counterparty is holding collateral securing the exposure under the contracts then the collateral must be sold to realise cash to cover the amount due.

Where the derivative contract was being used as a hedge, termination of the derivative contracts exposes the counterparty to the underlying risk. The counterparty must then enter into new contracts at current market prices to re-hedge itself to avoid additional risk. Hedging must generally be done on a contract by contract basis with limited scope for netting.

The entire process is complex and time consuming meaning that the amount of losses sustained may not be known with certainty for some time.

A bankruptcy or Chapter 11 filing may also trigger contracts referencing the financially distressed firm. For example, the bankruptcy filing would have triggered such as credit default swaps ("CDS") contracts on Lehman Brothers requiring settlement of these contracts as well.

Where CDS contracts were held as hedges they would alleviate losses that would otherwise have resulted. In all cases, settlement triggers payments creating potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehmans totalled around $365 billion. If a party is unable to meet its obligations under a CDS on Lehmans then the process starts over again involving the new party.

Financial distress affects other parties through "contagion". Counterparties who had dealings with the distressed entity either suffer losses or suffer cash outflows as they meet termination payments. They may suffer additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality and solvency setting off falls in the price of their shares and rises in borrowing costs. If credit ratings are affected then this may trigger margin calls or other events that further threaten solvency.

Financial distress of any entity also affects the market. Volatility of asset prices increase reflecting liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity is reduced as the number of counterparties falls. Credit limits become scarce limiting the ability of firms to deal with each other. Uncertainty about the impact of financial distress of one entity on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms. Asset price falls trigger further cash calls and distress for other market players.

The process is complicated by a variety of factors. In any bankruptcy, the sheer number of contracts that must be dealt with can be large. Lehman Brothers, it is understood, had about 2 million contracts open. There are likely to be cases of incomplete documentation and errors that will need to be resolved. Operational risks and problems of logistics abound.

The bankruptcy proceedings inevitably accelerate the need to deal with difficult to value and illiquid assets. Action taken by the trustees and administrators in the best interest of creditors can adversely affect the overall market.

Bankruptcy law is jurisdiction specific and different sets of trustees and administrators will grapple with how to best manage the assets of a specific legal entity for the advantage of its creditors. In the case of Lehman Brothers, there are already disputes about transfers (totalling $8 billion) made between the English entity and the US companies. There may also be differences in approach in dealing with the assets. The US trustee in bankruptcy indicated that "time was of essence" in dealing with the assets. In contrast, the UK administrator anticipated a long drawn out affair. All this creates uncertainty about the impact on creditors and the market.

Assets held in a fiduciary capacity can become entangled in the process. Where Lehman Brothers acted as prime broker, hedge funds and other asset managers now face a cumbersome process and potentially lengthy delays in recovering investments held by Lehman. This affected around $45 billion in assets and $20 billion in short positions. The legal owners now are unable to deal with their assets but may face margin calls if the value of the positions deteriorates.

The true owners of these assets also become exposed to risk of losses where their assets (pledged to cover loans) have been re-lent by Lehmans to finance itself (a process known as "re-hypothecation"). This spreads the problem to hedge funds and asset mangers with no ostensible exposure to the bankruptcy.

These complex networks and links tie to together all participants in modern financial markets. The chains of risk spread problems from distressed financial institutions to weak institutions ultimately affecting even strong entities, seemingly remote from the problem.

The risk spreads through direct losses, calls on liquidity, the ability to fund or the uncertainty created that ultimately brings the ability to deal with confidence and security in financial instruments to a halt. Contagion resembles nothing so much as a hungry wolf pack that systematically hunts down weakened prey animals within a herd one by one.

Understanding of the detailed connections, whilst unglamorous, is increasingly the key to anticipating the evolution of the crisis and preventing exposure to events. It is also where long-term reform efforts of the financial system should be directed.

John W. Gardner once observed: "The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water." Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is exacerbating its risks.

© 2008 Satyajit Das All Rights reserved.

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