By Conor Ryan
Since the famous collapse of the Lehman Brothers in 2008, the inefficiency of the current resolution procedure for insolvent banks has been on the minds of everyone. When Lehman filed for bankruptcy protection, they had tens of thousands of individual derivative positions. Their trading counterparties rushed to close out these trades immediately with Lehman Brothers—seeking the return of collateral, as well. These obligations took years to unwind, and resulted in billions of swap-termination payments being made. Additionally, the fear investors had of the failure of other firms prompted mass withdrawal and general uncertainty in the markets.
There is a snowball effect of the aforementioned panic. In Lehman’s case: They maintained their large role in the U.S. housing market, even after the bubble began to correct, and they were considerably leveraged. A near-collapse by another Wall Street firm, Bear Stearns, spread speculation that Lehman Brothers may fail, itself. As the stock began to fall, the speculation grew—lowering the price of their stock, and prompting further speculation. Several hedge funds pulled their shares, and their short term creditors cut ties with the firm.
A special type of swap, the Credit Default Swap, is used, in incredibly basic terms, to insure against a default on a bond, or other fixed income product. The purchaser of a CDS agrees to make payments to the CDS seller until the maturity date of a contract, and in return for these payments, the seller agrees to pay off third party debt, if said party defaults on their loan. The buyer may purchase a CDS if they believe that the third party will fail to meet their debt. In the Lehman Brothers’ case, the price of CDS’s related to their debt spiked 66% in September 2008 as they became increasingly insolvent. This signaled the nearly unanimous belief that Lehman would inevitably default. Ironically, a large CDS seller named American International Group would have defaulted, itself, on the very credit default swaps they sold, if it weren’t for $85 billion in government bailout support.
Is there a solution that could slow, or even stop this devastating domino, rush-to-withdraw process?
Maybe. The International Swaps and Derivatives Association aims, according to its own mission statement, to “…[foster] safe and efficient derivatives markets to facilitate effective risk management for all users of derivative products.” Since 1985, it worked to make the market for over-the-counter derivatives, derivatives not sold on an exchange—but most sold often directly between financial institutions, safer and more efficient. By this intention, last week the ISDA drafted a protocol, to which eighteen global banks have agreed, wherein they have made swaps contract changes designed to reduce the damage unwinding failed firms inflict on resolution efforts, market stability, and most importantly, taxpayer dollars.
What is a swap, and what will this protocol do?
A swap is a derivative in which two parties ‘swap’ or trade cash flows of one another’s financial instruments. Swaps have many forms and countless applications for floating vs. fixed interest rates, foreign exchange rates, commodity prices, etc., but the main purpose is the advantageous use of another firm’s exclusive access to an above-mentioned variable. If a firm with a high credit rating swaps a $5,000 loan at a fixed 5% interest rate with an emerging firm with uncertain income given a $5,000 loan at a floating 6% interest rate—due to their low credit rating, the former could enjoy the lower borrowing cost (predicting that the floating interest rate will decrease)—while the latter, newer firm could enjoy the stability of a known, fixed rate—potentially boosting their credit rating. Interest rate swaps, often called plain vanilla swaps, allow both firms to capitalize on their comparative advantage.
The contract overhaul will require the trading counterparties of banks undergoing resolution proceedings to delay their contract termination rights in certain departments of the firm, and stay their demands for collateral, for 48 hours. This change will give regulators additional time to arrange the proceedings in an orderly way. Under the current bankruptcy laws, the counterparties of a bank’s swaps can essentially attempt to collect their collateral immediately—because swaps are exempt from any stay that would keep creditors of a failed firm from immediately calling the debt. If this is the law, what good is the protocol? The protocol has been accepted on an exclusively voluntary basis by Goldman Sachs, JPMorgan, Bank of America Corp., Bank of Tokyo-Mitsubishi UFJ, Barclays Plc, BNP Paribas SA, Citigroup Inc., Credit Agricole SA, Deutsche Bank AG, Mizuho Financial Group Inc., Morgan Stanley, Nomura Holdings Inc., Royal Bank of Scotland Group Plc, Societe Generale SA, Sumitomo Mitsui Financial Group Inc., and UBS AG.
However it has been, and likely will continue to be, rejected by asset management firms. Let’s analyse not only why the latter group would reject this type of agreement, but more curiously, why the former would welcome and applaud such an arrangement.
Various asset-management firms indicated they couldn’t willingly agree to the protocol. Their fiduciary duty, which is a legal responsibility to act exclusively in client’s, or other party’s, interests, prohibits asset managers from surrendering contractual protections—like the right to collect defaulted swap money early, for a less favorable position. Volunteering to do so may leave the asset managers vulnerable to lawsuits filed by their own clients, for failing to retrieve the client’s money as soon as possible. The remedy to the asset management firm resistance is a move by the Federal Reserve to make this overhaul a legal requirement. Fiduciary duties would not be considered if the immediate collection of debt and collateral was made illegal.
Why did the banks, listed above, endorse what is effectively a limit on their own rights?
General concern for the health of the financial system might be one explanation. Lehman-style bankruptcies affect all banks and hurt the entire economy. It is in the interest of everyone to have an organized system in place to wind down a failing firm. This protocol may prevent such chaotic crashes from happening again.
But, as Peter Eavis points out, in his New York Times article: Change in Derivatives Contracts Only Goes So Far, the banks themselves may also have benefited.
“There is a notable gap in the contract overhaul that suggests the banks were keen to protect the status of their derivatives business. In one important situation, the contract change does not, in fact, delay early termination rights on derivatives.” For example, under circumstances where a bank’s derivatives trading entity files for bankruptcy, counterparties would still be able to end their trades early. The 48 hour stay on termination rights prevents the bankruptcy of said entity from setting cross-default rights, which is the right of a lender to bar access to balances in all loan accounts, and even apply all available balances in any account of the borrower to satisfy a loan in default. Counterparties of the failing firm could pillage the entirety of the firm’s accounts, creating more issues for other non-derivative trading counterparties and causing general mayhem on a large network of market participants. This is undesirable, and the ISDA asserts that the weekend pause will allow the regulatory bodies enough time to unwind a sinking firm, or even enough time for the firm to find a solution towards financial recovery. The domino effect would, in theory, be lessened, and the two days would act as a calming ‘deep breath’ for the firm and its trading partners.