Streetwise Professor

March 13, 2010

A Dog That Didn’t Bark

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:34 pm

The Valukas report on Lehman makes for interesting reading.  One of the most interesting things in the report is what isn’t in it: specifically, OTC derivatives.  Given the hyperventilating over the role of OTC derivatives in the financial crisis, this is quite important news.

Yes, OTC derivatives are mentioned, but in only the most perfunctory way.  Valukus concludes that Lehman’s methods for valuing its OTC derivatives was sound, and that alternative valuation methods gave very similar estimates of the value of Lehman’s positions.  Moreover, he notes that Lehman’s OTC derivatives positions were in the money to the tune of $21 billion, which represented only about 3.3 percent of the firm’s assets.  And that’s about it.

It is clear that the OTC derivatives were not the problem with Lehman.  Indeed, they were arguably the only thing that WASN’T a problem with the firm.  The huge losses were in residential real estate-related positions, commercial real estate, private equity, and leveraged loans.

Even the collateral and contagion issues were associated with other activities, notably repo funding.  In this regard, its interesting to note that, unsurprisingly, the mechanism that is often held out as the way of protecting the safety of the system—collateral—is actually what fed the death spiral.

The report also should open some eyes about the other supposed magic bullet—clearing.  Valukas concludes that there is a colorable case against the CME to claw back losses that resulted from the sale at a deep discount of Lehman’s house positions with the CME clearinghouse.  Valukas states, however, that preemption under the Commodity Exchange Act, the immunity of self-regulatory organizations, and the safe harbor provisions of federal bankruptcy law may shield the exchange from these claims.  I don’t know much about the first two things, but based on my knowledge/experience it is very plausible that the safe harbor provisions would apply here.

But that’s not the main thing of interest here.  It is evident that the Lehman bankruptcy posed risks to the CME clearinghouse, and hence its members.  After finding out about the impending bankruptcy, the CME ordered Lehman to trade for liquidation only, but the firm added to its positions over the next couple of days.  Moreover, the exchange failed in its initial attempt to get members to buy Lehman’s positions in bulk; it decided on this approach after concluding that liquidating the positions on the open market would have been extremely disruptive, given their size and the chaotic conditions in the market.  Several days later the positions were auctioned in bulk, but only at a steep discount.  Resolution of the problem clearly stressed the CME.  (There’s nothing in the report about what happened with SwapClear.  It would be interesting to know more about that.)

Note that the CME clearinghouse was at risk while these positions were still held at Lehman.  The risk posed by these positions didn’t magically disappear.  Moreover, note that what sparked the crisis was Lehman’s balance sheet risk, not the risk of its cleared positions.  This is the kind of risk that clearinghouses have little ability to measure, manage, or price.

In the end, the CME worked through the problems, though there were doubtless some sleepless nights.   Yes, the clearing process worked, but so did the OTC market.  The point is that the failure of a big member posed a big risk to the clearinghouse—and hence its members.  Clearing doesn’t make risk go away, or eliminate systemic risk.

In brief, the Valukas report on Lehman does not comport with the received narrative of the crisis, in which OTC derivatives play a central, and malign, role, and in which clearing is the panacea.  The narrative is so entrenched, however, I doubt that the facts will make any difference.  It will be interesting to see whether the Usual Suspects acknowledge this reality.  I am not holding my breath.

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