Streetwise Professor

May 6, 2010

A Second Voice in the Wilderness

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 2:24 pm

Harvard’s Mark Roe has an oped in today’s WSJ where he opines that clearing is NOT the “magic bullet” for systemic risk.  I definitely agree with that conclusion, as readers of SWP certainly know.

Several of Mark’s arguments echo the ones I’ve been making for the past two years.  First, they can create a moral hazard, and there is room to doubt that they have the requisite information to price counterparty risk properly:

The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline. [That’s the moral hazard point.]

Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be. [That’s the information point.]

Second, they can create a systemic risk:

Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse’s failure could do.

AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.

The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That’s good if it protects the clearinghouse. But it’s bad if it starts a run on a weakened but important bank.

. . . .

Clearinghouses can help manage some systemic risk if they’re run right. If not, they can become the Fannie and Freddie of the next financial meltdown.

Third, by allowing multi-lateral netting, clearing gives derivatives counterparties priority over other creditors, a point I first made back in ’08.  This is systemically ambiguous.  There is no guarantee that the derivatives counterparties are more systemically important, or more vulnerable to contagion, than other claimants.  For instance, reducing the payoffs that the buyers of a big intermediary’s short term paper obtain in the event of a bankruptcy by reshuffling priority imposes bigger losses on these creditors.  In the Lehman case, these creditors included money market funds who had bought Lehman commercial paper; the threat of a run on the money market funds led the Fed to guarantee them.

Where Mark and I part company is on bankruptcy treatment of derivatives.  He believes that all aspects of the bankruptcy code that give priority to derivatives counterparties should be eliminated.  Although I (see above) concur that changing priorities can be problematic, I also believe that treating derivatives exactly the same as other debts is problematic too.  Indeed, I think that there is a good argument for several of the safe harbor provisions.

I’ve been planning to write an extended post on this issue, and still hope to, so I’ll just summarize here.  First, the bankruptcy rules allow derivatives counterparties to seize collateral, whereas other creditors are stayed, meaning they cannot do so.  The reason this makes sense is that whereas in traditional debt the amount of exposure is limited to the face amount of the borrowing (plus interest owed), the exposure is potentially unlimited in derivatives.  Derivatives traders use collateral to limit their exposure; staying them would expose them to unlimited risk.

Second, the rules allow termination and close out netting of defaulted derivatives positions.  Without such termination and netting, (a) a defaulter’s counterparties would be locked into positions that generate unhedgeable risk, and (b) could expose such counterparties who have winning and losing positions with the defaulters to having to pay the bankrupt’s estate on the losing positions and not getting much back on the winning ones.  This is particularly problematic in a dealer model in which dealers tend to run matched books (or close to it).  With termination and close out netting, their exposure is related to their net positions.  Without it, it could be as large as their gross positions, which are a multiple of their net.  The dealer market maker model would not be sustainable under these conditions.   No doubt there would be various work arounds, but these are likely to be very costly and impede greatly the ability of the market to serve its risk transfer functions.

So Mark and I would agree that dictating CCPs is a bad idea; we would disagree on the advisability of wholesale changes in the treatment of derivatives in bankruptcy.

I know that Mark also shares my concern about the psychology that underlies the fixation on clearing mandates as the panacea to systemic risk.  There is a palpable obsession with “solving” the systemic risk problem.  Clearing has been seized on as this solution.  Groupthink has taken over, and there is virtually no questioning or critical analysis of clearing as it is, as opposed to clearing as people wish it to be. There is this rather unsettling similarity to a cult; it is like clearing is the space ship that will take the believers to a better place.  Or to a belief that there is a magic pill or painless diet that will cause one to lose weight and keep it off.  The thought is comforting.  It’s easy.  This makes people unwilling to ask uncomfortable questions.

This desire to “solve” systemic risk in one step is especially troubling because it bears the seeds of the next crisis.  The thing that is most likely to breed complacency is a belief that a problem has been solved.  As Mark, and I and others, have argued, clearing is not a foolproof solution, but has its own risks.  Overlooking those risks is a very dangerous thing.

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  2. “The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway.”

    As opposed to the current method, where the taxpayers reimburse Goldman Sachs for its irresponsible counter-party risks? 🙂

    You “experts” should get acquainted with the method that clearinghouses use to greatly reduce their own exposure. It’s called “daily Mark-To-Market margin call”:

    That’s why clearinghouse is safer than OTC.

    To be fair, MTM doesn’t work too well when the underlying is illiquidly traded. But it is still better than nothing.


    Comment by RTR — May 21, 2010 @ 7:14 am

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