Friday, December 18, 2009

Weakening derivatives’ super-priority

Original posted on Reuters by Felix Salmon:

Thanks to Brad Miller for pointing me to Mark Roe’s excellent column on super-priority for derivatives in bankruptcy:

True, somebody has to win and somebody has to lose when there is not enough money to go around. But these super-priorities warp the financial industry’s incentives to avoid problems… If financial players set their deals up perspicaciously with enough collateral, they need not worry if a counterparty such as AIG or Lehman collapses, as they will be paid before regular creditors. Some players – Goldman Sachs and JPMorgan are those talked about – set up parts of their AIG and Lehman deals to take advantage of these super-priority provisions. Knowing now what can happen in a financial meltdown, other financial players will do the same in the future, making the financial system more fragile…

If the derivatives and repo transactions were not so favourably treated in bankruptcy, financial players would seek other ways to protect themselves. That effort would channel them into stabilising the financial system or at least into making sure they were dealing with stable counterparties…

Priority facilitates liquidity and risk-spreading, but others pay for part of those benefits because they lose in bankruptcy and the financial system is potentially rendered less stable…

Priority proponents say we should fear financial contagion: one institution defaults and then its counterparty cannot meet its own obligations. Priority, they say, helps to contain the contagion. This could be so, but the opposite can also be true. We saw last year that priority also spreads contagion: as AIG and Lehman weakened, financial counterparties made legitimate collateral calls that, without their super-priority, would not stick in bankruptcy. This meant more of the weakened institutions’ counterparties knew that they would have to make similar collateral calls to stay even. This run-like process further weakened AIG and Lehman, and their weaknesses spread outward.

I’m particularly impressed by the way in which Roe makes a clear distinction between liquidity and stability — two things which are too often conflated. Indeed, in extremis, liquidity can sometimes be a bad thing, insofar as excess liquidity in one area of the markets (most likely Treasuries) can act as a super-magnet, unhelpfully pulling risk capital from everywhere else.

And there’s another problem with derivatives super-priority, which Roe doesn’t delve into: it encourages financial institutions to recast ordinary trades as derivatives contracts, in a multi-trillion-dollar game of beggar-my-neighbor where everybody needs super-priority because everybody else has it. The losers, of course, are less sophisticated investors who are naive enough to play in cash markets and buy real securities.

Goldman Sachs has sworn up and down that it was always fully hedged in its dealings with AIG. But it can only credibly say that because of super-priority provisions. Without super-priority, Goldman would never have allowed itself to amass such an enormous exposure to AIG, and AIG as a result would have been less vulnerable to a run from derivatives counterparties with collateral demands.

So let’s hope that derivatives super-priority is ended as part of an eventual financial-reform bill. Along with giving regulators the ability to treat late collateral grabs as a voidable preference in bankruptcy.

1 comment:

Riskman said...

You've got to be kidding! OTC derivatives and repo margin operates the same way as a futures exchange. Appropriate margin posting stabilizes the system - not weakens it.

The issue at hand is margin linked to ratings provided by the rating agencies. It means that an institution is putting it's stability in the hands of Moody's or S&P - and that's a dangerous practice. Because a sudden downgrade causes a margin call, creating a potential downward spiral.

Don't make blanket statements such as super-priority in itself can create stability problems