Thursday, April 15, 2010

Pirrong on the CME and Lehman

Original posted on Reuters by Felix Salmon:

Craig Pirrong has a thoughtful response to the unredacted Valukas report on the CME and Lehman, and in particular to my take on it. He explains clearly the reasons why Lehman’s CME positions were sold for $1.2 billion less than their market value:

Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy. Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions. Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process. In these circumstances, it was inevitable that firms would assume these positions only at discounted values.

So given all that, why did the CME auction off the positions? Because if it hadn’t, then it was theoretically possible that Lehman’s margin positions might not have sufficed to cover the losses associated with the positions. And in that case the CME would have become a Lehman creditor, and it didn’t want to risk that. Pirrong writes:

Clearing does not make risk disappear. The experience of CME with the Lehman situation shows that clearly. Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system. It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

It’s undoubtedly true that moving risks onto a clearinghouse increases the amount of risk which is in the clearinghouse. That’s a feature, not a bug, since the clearinghouse is focused, daily, on managing its tail risk. Because clearinghouses don’t trade daily, and don’t have a daily P&L, the tail risk is the one big risk they have to manage.

And yet when finally faced with such a risk, in the wake of Lehman’s failure, the CME’s reaction was to panic and spend any and all of Lehman’s collateral just to get the risk off its own books and somewhere — anywhere — else.

The point here is that the CME was incredibly cavalier with other people’s money, the minute those other people went bankrupt. If it had held onto the positions and they ended up being wound up or expiring at a profit, then the collateral would not have gone to the CME, it would have gone back to the Lehman estate. So the CME had no incentive to do that. Instead, it seized the collateral and threw it at Goldman Sachs, Barclays, and DRW Trading. It wasn’t the CME’s money, and it surely made those major CME clients very happy, so everybody wins. Except Lehman, and who cares about them — they’re bankrupt.

Here’s Pirrong:

The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity. That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.

Actually, the CME was trying to protect itself from any possible negative effects of a Lehman default, despite the fact that it possessed of billions of dollars of Lehman’s money: the mere existence of the CME helps to protect other clearing members from the counterparty risks associated with something like a Lehman default. That’s why central counterparty clearing is a good thing. The CME, however, was happy to pay out $1.2 billion of Lehman’s money to insulate itself from tail risk. Which is a very large sum of money. As Valukas says, there’s a colorable claim there from Lehman’s creditors.

And a comment from one of Felix's readers:

The CME did exactly what it is supposed to do – what it ought to be required to do by law if it isn’t already. There is absolutely no way a central counterparty should be taking on risk on the off chance of saving a few bucks for some creditors – the downside isn’t just a loss for the exchange, but collapse of the financial system.

I certainly hope there isn’t a “colorable claim” against the CME, because if there is then the current movement to put OTC derivatives onto central counterparties will vastly increase systemic risk.

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