Streetwise Professor

August 26, 2014

Merkel to Ukraine: Here’s Your Hat. What’s Your Hurry?

Filed under: Economics,Politics,Regulation,Russia — The Professor @ 8:50 pm

To compound Merkel’s obsequiousness to Putin, and her pushing Ukraine into his embrace, she broadly hinted that Ukraine should join Putin’s pet project, The Eurasian Union. Since Putin has made it clear that membership in the Eurasian Union and the Real EU are mutually exclusive, this is tantamount to turning Europe’s back on Ukraine and leaving it to Putin’s tender mercies.

Merkel’s remarks make it clear that her primary motive for abandoning Ukraine to Putin is to keep good relations with Russia, and to avoid riling Vlad:

“And if Ukraine says we are going to the Eurasian Union now, the European Union would never make a big conflict out of it, but would insist on a voluntary decision,” Merkel added.

“I want to find a way, as many others do, which does not damage Russia. We [Germany] want to have good trade relations with Russia as well. We want reasonable relations with Russia. We are depending on one another and there are so many other conflicts in the world where we should work together, so I hope we can make progress”

Nauseating. Like my grandfather said about a hostess trying to hint to  a guest who had overstayed his welcome that he leave: “Here’s your hat, Bob. Why are you in such a hurry to leave?”

For his part, during the Eurasian Union summit in Minsk, Putin made it clear that Ukraine had to choose between one EU or the other, and if it chose wrong, Russia would punish it. This is the fate that Merkel is willing to consign Ukraine to, so that Siemens can continue to sell to Russia, and Adidas can provide all the track suits that the gopniks desire:

In his public comments, Mr. Putin highlighted the dangers he said Russia faces if Ukraine pursues closer ties to the West. Since the onset of the crisis, Mr. Putin has accused the West of meddling in Ukraine’s internal affairs and trying to spoil its relations with Moscow.

Mr. Putin said that a trade agreement between Kiev and Europe will flood the Ukrainian market with European goods, which may then find their way into Russia. “In this situation Russia cannot stand idle. And we will be prompted…to take retaliatory measures, to protect our market,” Mr. Putin said.

The interesting thing about this is just what it betrays about what Putin thinks about Russian competitiveness. Yes, Russia is so great. Russia is so strong. Russia is a beacon to the world. But it can’t produce things its own people and businesses want.

Note the phrase: “take retaliatory measures, to protect our market.” Remind me again: didn’t Russia join the WTO? Apparently Putin is unclear on the concept.

Further note whom Putin is protecting Russian markets against: Europe. Apparently Angela is unclear on some concepts too.

Putin and many (most?) other Russians inveigh about Russophobia. When he says things like that, it’s hard to think of a bigger Russophobe than Putin. He evidently does believe that Russians are inferior, and in need of protection.

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August 19, 2014

A Couple of Quick Russia Hits: Putin’s Natural State & Selling E. Europe Down the (Don) River

Filed under: Economics,History,Military,Politics,Russia — The Professor @ 8:09 pm

Back when I started to blog about Russia in 2006-2007, I often pointed out that Russia under Putin was an archaic “natural state” rather than a modern one. The idea of the natural state was set out in work by North, Wallis and Weingast. In essence, it is a state with a distributed and diffuse potential for violence that is prone to break down into internecine conflict between armed factions. The only way this is avoided is to bribe the various factions with rents and privileges granted by the state (to give them a stake in maintaining the status quo rather than grasping for total control), and to keep them in an unsteady equipoise by pitting each against the other.

An article in the Moscow Times provides a very good description that brings home that point. This description of Putin’s version of the natural state cannot be bettered:

Putin’s staffing policies are based on the principle of ”loyalty in return for corruption.” Bureaucrats in the government, law enforcement and military are practically granted the right to steal and forbidden just one thing: criticism of the president.

The greatest enabler of Putin’s natural state is Germany, and most notably its appalling foreign minister, Steinmeier.

This piece by Dustin Duhez lays out in detail the intellectual underpinnings of Steinmeir’s beliefs and strategy. It is a very disturbing, but worthwhile read. In a nutshell: Steinmeier’s overriding objective is to maintain strong relations (especially commercial relations) with Russia, and is willing to sacrifice everyone between the Oder and the Don to do so. In other words, he is willing to sell eastern Europe down the river: the Don River, specifically.

Keep this in mind when watching Merkel’s visit to Kiev. At best she is equivocal and conflicted. At worst she is objectively pro-Putin.

Neither of these articles should be missed. One gives a good analysis of what makes Putinism tick. The other shows how the most powerful state in Europe works overtime to keep it oiled and wound.

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August 18, 2014

Wage Asymmetric Warfare: Unleash the SPR!

Filed under: Commodities,Economics,Energy,Military,Politics,Russia — The Professor @ 3:25 pm

The decline in the price of oil-Brent is down almost to $100/bbl, and Urals-Med is below that level-puts pressure on an already stressed Russian economy. And it especially puts pressure on a stressed Russian government budget, which balances at about $110+. What’s more, Russia is looking to replace private western funding with state support for its banks, and some corporations: recall my post yesterday which described how Sechin is panting after tens of billions of government money to replace western creditors. Further, Putin has made all sorts of promises, including lavish spending on the military and on infrastructure (e.g., a hugely expensive bridge over the Kerch Strait to Crimea). All of these add to the strains on the Russian budget.

Some of this is due to a weakening of the Russian economy for independent factors. Some of it is due to the sanctions.

The effectiveness of the sanctions could be enhanced by putting even further pressures on the Russian government. The most direct means of doing so would be through the price of oil, and short of persuading the Saudis to do a reprise of their 1986 act of flooding the market with oil, the best way to do that would be to release oil from the Strategic Petroleum Reserve.

Especially given the burst in US domestic oil production, the already weak case for maintaining a large reserve is even weaker. Moreover, since much of the oil in the SPR is Brent, and thus could presumably be exported, this would be a way of mitigating the distortions associated with the existing crude export ban.

The number of barrels that would actually flow to the market would presumably be somewhat lower than the amount released from the SPR, because some of the public storage would be replaced by private storage. (As I argued in 2011, this effect depends on market expectations regarding how the SPR would be used.) But the direction of the price effect is clear, and the price impact would not be trivial.

Putin is waging asymmetric war in Ukraine. (Though it is becoming less asymmetric, and more conventional, by the day.) Sanctions are an asymmetric form of warfare. A release of the SPR would be another asymmetric move that would impact Russia directly, and indirectly by enhancing the financial strains produced by the sanctions. There’s no substantive economic case for retaining the SPR at its current levels. Seems like an obvious move. Will Obama make it?

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August 17, 2014

This Never Happens, Right?: Regulators Push a Flawed Solution

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 6:06 pm

Regulators are pushing ISDA and derivatives market participants really hard to incorporate a stay on derivatives trades of failing SIFIs. As I wrote a couple of weeks ago, this is a problem if bankruptcy law involving derivatives is not changed because the prospect of having contracts stayed, and thus the right of termination abridged, could lead counterparties to run from a weak counterparty before it actually defaults. This is possible if derivatives remain immune from fraudulent conveyance or preference claims.

Silla Brush, who co-wrote an article about the issue in Bloomberg, asked me a good question via Twitter: why should derivatives counterparties run, if they are confident that their positions with the failing bank will be transferred to a solvent one during the resolution process?

I didn’t think of the answer on the fly, but upon reflection it’s pretty clear. If counterparties were so confident that such a transfer will occur, a stay would be unnecessary: they would not terminate their contracts, but would breathe a sigh of relief and wait patiently while the transfer takes place.

If regulators think a stay is necessary, it is because they fear that counterparties would prefer to terminate their contracts than await their fate in a resolution.

So a stay is either a superfluous addition to the resolution process, or imposes costs on derivatives counterparties who lack confidence in that process.

If this is true, the logic I laid out before goes through. If you impose a stay, if market participants would prefer to terminate rather than live with the outcome of a resolution process, they have an incentive to run a failing bank, and find a way to get out of their derivatives positions and recover their collateral.

This can actually precipitate the failure of a weak bank.

I say again: constraining the actions of derivatives counterparties at the time of default can have perverse effects if their actions prior to default are not constrained.

This means that you need to fix bankruptcy rules regarding derivatives in a holistic way. And this is precisely the problem. Despairing at their ability to achieve a coherent, systematic fix of bankruptcy law in the present political environment, regulators are trying to implement piecemeal workarounds. But piecemeal workarounds create more problems than they correct.

But of course, the regulators pressing for this are pretty much the same people who rushed clearing mandates and other aspects of Frankendodd into effect without thinking through how things would work in practice.

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Nationalize the Clearinghouses?

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 3:48 pm

Stephen Lubben has garnered a lot of attention with his recent paper “Nationalize the Clearinghouses.” Don’t get nervous, CME, ICE, LCH: he doesn’t mean now, but in the event of your failure.

A few brief comments.

First, I agree-obviously, since I’ve been saying this going back to the 90s-that the failure of a big CCP would be a catastrophic systemic event, and that a failure is a set of positive measure. Thus, planning for this contingency is essential. Second, I further agree that establishing a procedure that lays out in advance what will be done upon the failure of a CCP is vital, and that leaving things to be handled in an ad hoc way at the time of failure is a recipe for disaster (in large part because how market participants would respond to the uncertainty when a CCP teeters on the brink). Third, it is evident that CCPs do not fit into the recovery and resolution schemes established for banks under Frankendodd and EMIR. CCPs are very different from banks, and a recovery or resolution mechanism designed for banks would be a bad, bad fit for clearers.

Given all this, temporary nationalization, with a pre-established procedure for subsequent privatization, is reasonable. This would ensure continuity of operations of a CCP, which is essential.

It’s important not to exaggerate the benefits of this, however. Stephen states: nationalization “should provide stakeholders in the clearinghouses with strong incentives to oversee the clearinghouse’s management, and avoid such a fate.” I don’t think that the ex ante efficiency effects of nationalization will be that large. After all, nationalization would occur only after the equity of the CCP (which is pretty small to begin with) is wiped out, and the default fund plus additional assessments have been blown through. Shooting/nationalizing a corpse doesn’t have much of an incentive effect on the living ex ante.

Stephen recommends that upon nationalization that CCP memberships be canceled. This is superfluous, given the setup of CCPs. Many CCPs require members to meet an assessment call up to the amount of the original contribution to the default fund. Once they have met that call, they can resign from the CCP: that’s when the CCP gives up the ghost. Thus, a CCP fails when members exercise their option to check out. There are no memberships to cancel in a failed CCP.

Lubben recommends that there be an “expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable.” In effect, this involves the creation of a near unlimited liability regime for CCP members. The existing regime (which involves assessment rights, typically capped at the original default fund contribution amount) goes beyond traditional limited liability, but not all the way to a Lloyds of London-like unlimited liability regime. Telling members that they will be “expected” to recapitalize a CCP (which has very Don Corleone-esque overtones) essentially means that membership in a CCP requires a bank/FCM to undertake an unlimited exposure, and to provide capital at times they are likely to be very stressed.

This is problematic in the event, and ex ante.

Stephen qualifies the recapitalization obligation (excuse me, “expectation”) with “once that becomes systemically viable.” Well, that could be a helluva long time, given that the failure of a CCP will be triggered by the failure of 2 or more systemically important financial institutions. (And let’s not forget that given the fact that FCMs are members of multiple clearinghouses, multiple simultaneous failures of CCPs is a very real possibility: indeed, there is a huge correlation risk here, meaning that surviving members are likely to be expected to re-capitalize multiple CCPs.) Thus, even if the government keeps a CCP from failing via nationalization, the entities that it expects to recapitalize the seized clearinghouse will will almost certainly be in dire straits themselves at this juncture. A realistic nationalization plan must therefore recognize that the government will be bearing counterparty risk for the CCP’s derivatives trades for some considerable period of time. Nationalization is not free.

Ex ante, two problems arise. First, the prospect of unlimited liability will make banks very reluctant to become members of CCPs. Nationalization plus a recapitalization obligation is the wrong-way risk from hell: banks will be expected to pony up capital precisely when they are in desperate straits. My friend Blivy jokingly asked whether there will soon be more CCPs than clearing firms. An “expectation” of recapitalizing a nationalized CCP is likely to make that a reality, rather than a joke.

Second, the nationalization scheme creates a moral hazard. Users of CCPs (i.e., those trading cleared derivatives) will figure that they will be made whole in the event of a failure: the government and eventually the (coerced) banks will make the creditors of the CCP whole. They thus have less incentive to monitor a CCP or the clearing members.

Thus, other issues have to be grappled with. Specifically, should there be “bail-ins” of the creditors of a failed CCP, most notably through variation margin haircutting? Or should there be initial margin haircutting, which would intensify the incentives to monitor (as well as spread the default risk more broadly, and not force it disproportionately on those receiving VM payments, who are  likely to be hedgers) ? Hard questions, but ones that need to be addressed.

It is good to see that serious people like Stephen are now giving serious consideration to this issue. It is unfortunate that the people responsible for mandating clearing didn’t give these issues serious consideration when rushing to pass Frankendodd and EMIR.

Again: legislate in haste, repent at leisure.

 

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August 16, 2014

Sechin: Sanctions Don’t Hurt Rosneft, But I Need $42 Billion Because of Sanctions

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 2:46 pm

Igor Sechin, he of the ape drape, is asking the Russian government for $42 billion for Rosneft, to be paid from the National Wealth Fund. This would represent almost half of the value of that fund’s $86 billion. Sechin “said the company needed the money to help it cope with a ban on U.S. credits and loans with a maturity longer than 90 days, which European banks and investors have joined.”

This newfound fear of sanctions contradicts what Sechin and other Russian officials have said: they have dismissed them as irrelevant trifles.

I really don’t think that Sechin has become convinced that the sanctions do in fact pose a serious threat to Rosneft. This is just his way of trying to let no crisis go to waste, and get his hands on Russian government monies. Sechin has always fought tooth and nail against Medvedev’s repeatedly shelved plans to sell off a big stake in Rosneft: he doesn’t want nosy western investors cramping his style. The sanctions, and their alleged impact on Rosneft’s ability to borrow in the west, gives him an opportunity to show the door to pesky western creditors as well. Sechin no doubt believes that he can exert far more influence and power over the Russian government than he can over foreign bankers and traders. Bad, empire building investments; sweetheart contracts with favored supply firms; and tunneling funds are all easier when the main obstacles are government bureaucrats who can be bought off or threatened with horrible fates. The challenges are greater when outside investors and creditors are involved.

Sane Russian economics officials (there are some!) are aghast:

An anonymous official cited by Vedomosti called Sechin’s plan “horrible”, and another government source told the paper Prime Minister Dmitry Medvedev was unlikely to back it.

As if Medvedev matters.

I doubt Sechin will get his $42 billion, but I imagine he will get a lot more than zero. Maybe the $12 billion that Rosneft has to repay this year. Putin is likely to be sympathetic, given his decided autarkic turn.

In other possibly sanctions-related news, Gazprom is apparently relocating its London trading operations to Zug. To its discredit, Switzerland has refused to join in on EU sanctions, or to adopt serious sanctions of its own. Switzerland’s economy minister cautioned against joining EU sanctions, and advanced his country as a mediator with the Russians.

Which makes this Russian rant over the one timorous move that Switzerland has made truly revealing:

The Russian Foreign Ministry on Friday sharply criticized the Swiss government for restrictivemeasures against Russia related to Moscow’s stance on the Ukrainian crisis, saying such moves could harm bilateral relations.

“We express our disappointment in connection with these decisions taken by Bern,” the ministry said in a statement.

Earlier on Friday, the Swiss government decided to draft additional measures aimed at preventing the use of the territory of the Swiss Confederation to circumvent the existing EU sanctions against Russia. The government also confirmed the ban on transfers of dual-purpose products and technologies to Russia.

Those Russians. Poster children for Dale Carnegie.

But who could resist the appeal of a guy like this?:

sechin_ape_drape

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August 11, 2014

That Was Fast: Both the Price Controls and the “Speculative” Response

Filed under: Economics,Politics,Russia — The Professor @ 7:31 pm

In my post on the Russian food import ban, I predicted that Russia would impose price controls. And wouldn’t you know, on Saturday, only a few days after the ban was announced, Reuters reported that the government was “negotiating” price control agreements with domestic producers:

Russia may negotiate a price control agreement with domestic food producers to prevent speculative price hikes that would affect inflation after it banned half its agricultural imports from the West, the agriculture ministry said late on Friday.

Russia banned meat, fish, dairy, fruit and vegetables imports from the United States, the European Union’s 28 member states, non-EU member Norway, Canada, and Australia on Thursday in retaliation against sanctions over the Ukraine crisis.

Agriculture Minister Nikolai Fyodorov has acknowledged the ban would cause a short-term spike in inflation, but said he saw no danger in the medium or long term as Russia started to look elsewhere for substitute imports.

The ministry, referring to a meeting with food sector unions, said: “Participants at the meeting discussed the possibility of signing with producers and agricultural products processors an agreement on … price policy, to prevent any speculative rises in prices for agricultural products.”

You know how voluntary these “negotiations” are. And yeah, it’s a problem with “speculation.” No. It’s a problem with supply and demand. Speculation is just the messenger that delivers the bad news. Moreover, the speculation that is going on now (more on that below) is as much about the coming price controls as much as it is about the import ban itself.

The “negotiated” price controls are not a new innovation in Russia. The government did the same thing in 2007*. It is revealing of the nature of the regime, though. Communists would have imposed controls by fiat. A more corporatist regime, with fascist overtones, “negotiates” with corporations to achieve its objectives.

The Russians-and some commenters here-claim that alternative supplies will mitigate the effect of the ban on prices. There will be some response in the medium term, including finding alternative sources of supply as global trade flows adjust. Firms that now sell to Russia will sell to other markets, and some of the sellers in those markets will shift their supplies to Russia. But this process takes time, and what’s more, the fact that this pattern of trade flows isn’t in place now, means that it is costlier than the existing pattern. So even after the adjustment process is completed, food costs in Russia will be higher. This is especially likely to be the case for dairy and vegetables.

The time-limited nature of the ban, to the extent that market participants believe that it will indeed be lifted in a year, will limit the supply response. Suppliers must make investments to adjust flows, where investments include things like identifying new suppliers, negotiating agreements, and other transactions costs, as well as investments in plant, equipment, and people. Time limiting the ban reduces the return on these investments, reducing the amount of investment. Moreover, the uncertainty surrounding the ban, which is reinforced by its self-damaging nature, which raises questions about the rationality of the Russian government, as well as the inherent volatility of the Ukrainian criss. also tends to suppress investment. Why invest now? Why not wait and see what Putin does and how the situation develops?

All this means that the cost increases are likely to persist.

In the face of higher costs, price controls will lead to shortages, and declines in quality. In addition to reducing output, Russian producers, especially those selling value-added, more extensively processed or packaged goods, can respond to the combination of costs and controls by reducing quality, by using lower quality inputs, adding fillers, utilizing flimsier packaging, selling past sell by date goods, taking less care and expense in preserving perishable goods, and in a thousand other ways. It is impossible for the government to negotiate or enforce arrangements that eliminate these sorts of stealth price increases.

Russians-speculators!-apparently know what is coming. They are starting to party like it’s 1989. Shelves in some stores are emptying. The imposition of controls, negotiated or not, will mean that they will not be refilled, or that they will be stocked with inferior products.

Putin will have to crank up that propaganda machine, and quick.

*Post 134. Hard to believe. Well over 2500 posts as of today.

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August 1, 2014

The Real Reason Adidas Opposes Sanctions: It Can’t Afford to Lose the Gopnik Market

Filed under: Economics,Politics,Russia — The Professor @ 4:27 pm

Adidas stock got pounded earlier this week, following a drastic cut in its revenue and profit forecasts.

The company blamed many factors, including Russia:

Adidas also said it was scaling back investment in Russia, where it runs more than 1,000 stores, due to a fall in the rouble since the start of the Ukraine crisis and increasing risks to consumer sentiment and spending there.

“Current tensions in the region point to higher risks to the short-term profitability contribution from Russia/CIS,” it said, adding it would significantly reduce its store opening plan for 2014 and 2015 and increase the number of store closures.

Adidas had said as recently as last month it had not seen any impact on its business in Russia – beyond the translation effect of the weaker rouble.

The gopniks need to buy more track suits! Sanctions may destroy the gopnik market! Now we know why Adidas has been pressing Angela to go easy on Putin.

This brings to mind a hilarious incident from the spring, when Russian Communist Party head Gennady Zyuganov shocked Russian sensibilities by wearing an Adidas track suit while laying flowers on Stalin’s grave:

Russian Communist Party leader Gennady Zyuganov caused a stir on the Russian blogosphere for laying flowers at the grave of Soviet dictator Josef Stalin while wearing an Adidas tracksuit jacket.

A Twitter user who registered under the name “Josef Stalin” quipped: “Zyuganov showed up in an Adidas tracksuit top, a white shirt and dress shoes. [I'd have had him] shot for this outfit!”

Zyuganov made the dress code blunder on Sunday at a ceremony on Red Square to mark the 92nd anniversary of the establishment of the pioneers, a Soviet-era Communist youth organization.

But the best part was Zyuganov’s excuse:

He told the Russian News Service radio station that he wore it because “nobody makes good tracksuits yet in our country.” He did not specify why he had to wear a tracksuit jacket at all, but perhaps it was its red color that made the Communist leader warm to the garb.

His gaffe may have caught people’s attention because Adidas goods symbolized capitalist swank for many Soviet people under the Communist regime.

Yeah. Capitalist swank. That’s why the Russian equivalent of chavs wear them.

Rest assured. Zyuganov swears he has no promotional contract with Adidas. It was purely a fashion statement.

If Russia can’t make a good track suit, then good luck with that self-reliance that Putin, Lavrov, Medvedev and Rogozin the Ridiculous are promising in high tech goods, military equipment and finance in the aftermath of the sanctions. I’m sure it will all work out swell.

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July 31, 2014

Treasury Channels SWP: Possible Tightening of the Sanctions Net

Filed under: Derivatives,Economics,Russia — The Professor @ 9:48 am

In earlier posts I pointed out a couple of loopholes in the sanctions related to derivatives. Derivatives were explicitly excluded from the mid-July US sanctions imposed on Rosneft and other companies.

One loophole is that US persons can effectively provide credit to Rosneft and other firms subject to US sanctions but not to sanctions by the EU (or other foreign jurisdictions) by selling credit protection on the sanctioned companies to non-US person financial institutions, who could then expand their lending to offset the effect of the inability of US financial institutions to lend directly.

The other loophole is that a sanctioned firm (even one sanctioned by the EU, because its sanctions will evidently include the same loophole) can synthetically create a long-term bond that it cannot issue directly due to the sanctions by borrowing for 90 days, rolling the borrowing, and entering into a payer swap. The swap would effectively convert the floating, short-term rate into a longer-term fixed rate, thereby substituting for a prohibited long-term loan or debt security.

Neither of these is perfect substitutes for the banned transactions, but they are fairly close substitutes.

According to Bloomberg, the US Treasury is considering adding derivatives and short term borrowings to the list of transactions prohibited under the sanctions:

The U.S. might move to limit derivatives trading and short-term loans with Russian companies if sanctions already imposed fail to sway President Vladimir Putin to end support for rebels in eastern Ukraine.

U.S. citizens and businesses are still permitted to trade in outstanding debt of any maturity and new short-term debt and derivatives with sanctioned Russian companies. Restrictions on money-market financing and derivatives could be imposed if tougher penalties are necessary, said a Treasury Department official who asked not to be named because further options are still being discussed.

These limits would close off the loopholes that exploit derivatives and short-term borrowing.

I wonder whether these moves had been considered all along, or whether UST learned that financial institutions and sanctioned companies were exploring those loopholes. Interesting development, regardless.

 

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July 30, 2014

ISDA Should Stay Its Hand, Not Derivatives In Bankruptcy

Filed under: Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:39 pm

I’ve been meaning to write about how derivatives are treated in bankruptcy, but it’s a big topic and I haven’t been able to get my hands around it. But this article from Bloomberg merits some comment, because it suggests that market participants, led by ISDA, are moving to a partial change that could make things worse if the bankruptcy code treatment of derivatives remains the same.

Derivatives benefit from a variety of “safe harbors” in bankruptcy. They are treated very differently than other financial contracts. If a firm goes bankrupt, its derivatives counterparties can offset winning against losing trades, and determine a net amount. In contrast, with normal debts, such offsets are not permitted, and the bankruptcy trustee can “cherry pick” by not performing on losing contracts and insisting on performance on winning ones. Derivatives counterparties can immediately access the collateral posted by a bankrupt counterparty. Other secured debtors do not have immediate access to collateral. Derivatives counterparties are not subject to preference or fraudulent conveyance rules: the bankruptcy trustee can claw back cash taken out of a firm up to 90 days prior to its bankruptcy, except in the case of cash taken by derivatives (and repo) counterparties. Derivatives counterparties can immediately terminate their trades upon the bankruptcy of a trading partner, collect collateral to cover the bankrupt’s obligations, and become an unsecured creditor on the remainder.

It is this ability to terminate and grab collateral that proved so devastating to Lehman in 2008. Cash is a vital asset for a financial firm, and any chance Lehman had to survive or be reorganized disappeared with the cash that went out the door when derivatives were terminated and collateral seized. It is this problem that ISDA is trying to fix, by writing a temporary stay on the ability of derivatives counterparties to terminate derivatives contracts of a failed firm into standard derivatives contract terms.

That sounds wonderful, until you go back to previous steps in the game tree. The new contract term affects the calculations of derivatives counterparties before a tottering firm actually declares bankruptcy. Indeed, as long as preference/fraudulent conveyance safe harbor remains, the new rule actually increases the incentives of the derivatives counterparties to run on a financially distressed, but not yet bankrupt, firm. This increases the likelihood that a distressed firm actually fails.

The logic is this. If the counterparties keep their positions open until the firm is bankrupt, the stay prevents them from terminating their positions, and they are at the mercy of the resolution authority. They are at risk of not being able to get their collateral immediately. However, if they use some of the methods that Duffie describes in How Big Banks Fail, derivatives counterparties can reduce their exposures to the distressed firm before it declares bankruptcy, and crucially, get their hands on their collateral without having to worry about a stay, or having the money clawed back as a preference or fraudulent conveyance.

Thus, staying derivatives in a bankrupt firm, but retaining the safe harbor from preference/fraudulent conveyance claims, gives derivatives counterparties an incentive to run earlier. Under the contracts with the stay, they are in a weaker position if they wait until a formal insolvency than they are under the current way of doing business. They therefore are more likely to run early if derivatives are stayed.

This means that this unbalanced change in the terms of derivatives contracts actually increases the likelihood that a financial firm with a large derivatives book will implode due to a run by its counterparties. The stay may make things better conditional on being in bankruptcy, but increase the likelihood that a firm will default. This is almost certainly a bad trade-off. We want rules that reduce the likelihood of runs. This combination of contract terms and bankruptcy rules increases the likelihood of runs.

This illustrates the dangers of piecemeal changes to complex financial systems. Strengthening one part can make the entire system more vulnerable to failure. Changing one part effects how the other parts work, and not always for the better.

Rather than fixing single parts one at a time, it is essential to recognize the interdependencies between the pieces. The bankruptcy rules have a lot of interdependencies. Indeed, the rules on preferences/fraudulent conveyance are necessary precisely because of the perverse incentives that would exist prior to bankruptcy if claims are stayed in bankruptcy, but creditors can get their money out of a firm before bankruptcy. Stays alone can make things worse if the behavior of creditors prior to a formal filing is not constrained. All the pieces have to fit together.

The Bloomberg article notes that the international nature of the derivatives business complicates the job of devising a comprehensive treatment of derivatives in bankruptcy: harmonizing bankruptcy laws across many countries is a nightmare. But the inability to change the entire set of derivatives-related bankruptcy rules doesn’t mean that fixing one aspect of them by a contractual change makes things better. It can actually make things worse.  It is highly likely that imposing a stay in bankruptcy, but leaving the rest of the safe harbors intact, will do exactly that.

ISDA appears to want to address in the worst way the problems that derivatives can cause in bankruptcy. And unfortunately, it just might succeed. ISDA should stay its hand, and not derivatives in bankruptcy, unless other parts of the bankruptcy code are adjusted in response to the new contract term.

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