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Ties That Bind « The Washington Independent

Image has not been found. URL: /wp-content/uploads/2008/10/federal-reserve.jpgU.S. Federal Reserve Headquarters (Flickr: NCinDC)

The complex structure of modern capital markets is increasingly the cause of financial crises. External shocks like a decline in housing prices are intensified as they move through the convoluted chains of dealings that link market participants. Concentration of trading among a small group of dealers only heightens the many risks.

In hindsight, the Federal Reserve’s decision not to bail out Lehman Bros. was a major miscalculation that helped generate the wave of financial anxiety, distrust and uncertainty that doomed American International Group and other institutions. It also helped freeze up credit markets that are only now beginning to thaw. If government overseers had shown greater appreciation and knowledge of the plumbing of the financial system they regulate, some form of Lehman might still be around.


Illustration by: Matt Mahurin

In any case, central bankers and finance ministers frequently act like Pritzker Prize-winning architects charged with trying to unstop clogged plumbing. As a result, they find, as Woody Allen described: “Not only is there no god, but try getting a plumber on weekends.”

In fairness, even experienced professionals struggle to understand the structure of modern markets. One is Jeremy Grantham, chairman of GMO. He recently rated his knowledge of the markets this way: “I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. … It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect [to solve the financial crisis].”

One consequence of the system’s complexity and interconnectedness is that it is difficult to analyze the solvency of financial institutions. The speed with which liquidity and access to funding can evaporate — as with the Dutch bank, Fortis — renders financial statements virtually meaningless.

Agreements governing a firm’s ties to other financial companies also increasingly affect perceptions of its solvency. For example, the downgrade of AIG to below an “AA” credit rating triggered margin calls in excess of $10 billion from the company’s lenders. It also gave AIG’s outside trading parties the right to terminate certain contracts, triggering losses of $4 billion to $5 billion. AIG did not have the resources to meet its obligations — and the government had to step in and bail out the world’s largest insurer.

How a company’s financial distress will affect the overall system can depend on how it is restructured. In the case of Lehman, it was the holding company that filed for bankruptcy protection. The investment bank’s other businesses continued to run. That means financial institutions doing business with Lehman were differently affected by its collapse.

The effects of the demise of Washington Mutual, the largest bank failure in U.S. history, were different. The Federal Deposit Insurance Corp. seized the Seattle thrift following a wave of deposit withdrawals. J.P. Morgan Chase subsequently agreed to acquire WaMu’s banking operations and assume its loan portfolio in a $1.9 billion deal engineered by the government regulator. WaMu’s customers were largely unaffected.

Image has not been found. URL: /wp-content/uploads/2008/10/lehman-225x300.jpgLehman Bros., New York (Flickr: James Chen)

What’s predictable when financial institutions fail is that investors lose money. With Lehman, unlucky creditors included banks on every continent that had bought Lehman securities and bonds. Because J.P. Morgan did not assume WaMu’s senior unsecured debt, subordinated debt and preferred stock, investors in those financial instruments lost out.

Those losses can be steep. Market estimates of how much Lehman’s debt is worth range from 10 cents to 15 cents on the dollar — a potential loss to investors of 85 percent to 90 percent. In general, recovery rates will be determined by the nature of the assets that Lehman’s counterparties hold — private equity stakes, principal investments, hedge-fund equity, complex slices of risk in structured financial instruments and derivatives. The difficulty in valuing these assets — and the illiquidity of others — may exacerbate investor losses.

One way to examine the complexity of today’s financial plumbing is to focus on a Chapter 11 bankruptcy filing. When a firm files for bankruptcy, all contracts that it has had with trading partners — and the number can be huge — would usually terminate. Lehman reportedly had about 2 million open contracts.

Add to the sheer number of contracts the possibility of incomplete documentation, or plain error. Then throw in operational risks and problems of logistics.

All this triggers a complex chain of events.

The net value of an individual financial contract between a counterparty and a distressed firm may be settled if the contract specifies the amount. If it is the counterparty that owes the amount, it must pay it to the bankruptcy trustee. This means an immediate — and possibly large — cash outlay for the non-defaulting party. If the distressed firm owes the amount, then the counterparty must supply documentary proof to the bankruptcy trustee and await payment.

If the counterparty holds collateral to secure its exposure, then the collateral must be sold to cover the amount due.

If the contract was used as a hedge, its termination exposes the counterparty to its underlying risk. The counterparty must then enter into new contracts to re-hedge itself to avoid additional risk. In general, hedging must be done on a contract-by-contract basis, with limited scope for retrieving net value.

Because this process is complex and time-consuming, the amount of losses sustained may not be certain for some time.

The Chapter 11 filing may also trigger contracts concerning the firm itself. For example, Lehman’s bankruptcy filing would have required settlement of credit default swap contracts that, in effect, insured some of the investment bank’s debt. If a Lehman counterparty held these contracts as hedges, they would ease its losses. In all cases, settlements would create potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehman’s debt, for example, came to about $365 billion.

A firm’s bankruptcy affects other parties through “contagion.” Counterparties that had dealings with the distressed firm either face losses or suffer cash outflows as they meet termination payments. They may face additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality, possibly leading to a fall in their share prices and increases in their borrowing costs. If credit ratings are affected, margin calls may be the result, further threatening solvency.

The overall market is also affected. Greater volatility in asset prices may reflect liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity falls as the number of counterparties drops. Credit becomes scarce, limiting firms’ ability to deal with each other.

Uncertainty over the fallout of a company going under can cause trading in the inter-bank lending market to freeze up. That, in turn, further increases volatility and exposes weaker firms to failure.

Bankruptcy proceedings inevitably accelerate the need to deal with assets that are difficult to value or are illiquid. In resolving the matter, trustees and administrators, acting in the best interest of creditors, can adversely affect the overall market.

And because bankruptcy law is jurisdiction-specific, different sets of trustees and administrators have to grapple with how to best manage the assets of a firm to settle with its creditors. In the case of Lehman, there are already disputes about transfers, totalling $8 billion, made between the investment bank’s London office and those in the United States.

They may also differ in their approaches to dealing with assets. The U.S. trustee in the Lehman bankruptcy indicated that “time was of essence” in dealing with the bank’s assets. In contrast, the British administrator anticipated a long drawn-out affair. All this creates uncertainty about the effect of Lehman’s demise on its creditors and the overall market.

Assets held in a fiduciary capacity can become entangled in this mess. Where Lehman acted as their prime broker, hedge funds and other asset managers face potentially lengthy delays in recovering their investment. About $45 billion in assets, and $20 billion in short positions, are affected. Here’s another problem: Though unable to deal with their assets, legal owners may face margin calls if the value of their positions deteriorates.

A bankruptcy filing can thus reveal the complex networks that tie together all participants in modern financial markets. The chains of risk can spread problems from distressed financial institutions to weak ones, and can ultimately affect even strong firms seemingly remote from the problem.

Assume Bank A, a sound financial institution, has large hedges with Bank B, another sound institution. If a counterparty to Bank B has difficulties, its resulting losses may imperil Bank B, which, in turn, might affect Bank A.

The risk spreads through direct losses, liquidity calls, funding problems or uncertainty. Confidence in the financial system is undermined and financial transactions grind to a halt. It’s a contagion that resembles a hungry wolf pack systematically hunting down the weakest prey in a herd.

Understanding the financial system’s detailed connections, while unglamorous, is the key to anticipating the evolution of a crisis and preventing further exposure to events. It is also where long-term reform efforts should be directed.

John W. Gardner once observed: “The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water.”

Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is greatly increasing its risks.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

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