"Those who cannot remember the past are condemned to repeat it."
--George Santayana, 1906.
"Man's capacity for justice makes democracy possible; but man's inclination to injustice makes democracy necessary."
--Reinhold Niebuhr, 1944.
This is a re-print of a letter sent to President Bush in 2008. Though incredibly stilted, the discussion focusses on fixing the corruption of the derivatives market. On the banking side, the proposed course was simple. Bring back the Glass-Steagall to separate of the banks and investment banks with some additional parameters focussed on proprietary trading.
To implement this proposal would require the express-bankruptcy resolution of the key 'culprit' banks with systemic risk. In the the interim, the Federal Reserve could run the ABA cash transfer system to administer the overnight lending system during the industry re-structuring.
==================
SUMMARY
PROPOSAL for REFORM of CREDIT DERIVATIVES
Summary & Conclusion.
The credit derivatives markets – principally but not
exclusively for credit default swaps – represent the accumulation, over a
decade of active trading, of millions of over-the-counter (OTC)
transactions. These contracts act like
credit insurance policies since pay-out patterns resemble those of bond
insurance or options. This brief
thought-experiment identifies a simple solution to an emerging crisis. This
solution will test political courage since it strikes at the heart of the
current, albeit dysfunctional, credit derivatives market. The success of this plan will not solve the
credit crunch but will remove an ongoing cause for alarm, thus encouraging
regulators to focus support on regional and community banks. These reforms will not enmesh the Federal
government in private markets in favor of a bold one-time intervention to set
them right. There are two key precedents
underlying this problem-&-solution set: the London reinsurance spiral of the 1980s and
the intervention led by the Federal Reserve after Long-term Capital Management Llc failed in the 1990s.
Background of the Credit Derivatives Market. The credit default swap market
tried to replicate the success of the earlier markets for interest rate swaps
(e.g., fixed vs floating coupon rates) and options (i.e., caps and floors) over
two decades starting in the mid-1970s. Like caps and floors, credit derivatives
were contingent payments upon the occurrence of explicit events. Like interest rate swaps, these derivatives
referenced a notional and, for speculators, unowned security to fix the amount
of contingent payments. Credit
derivatives sold by banks served as substitute guaranties of third-party bond
or credit issuers (i.e., “reference parties”) for the benefit of derivative
counterparties, usually other banks or mono-line bond or financial guaranty
insurers. Global money-center and
investment banks warmed up to these instruments since they conferred steady
intermediation fees without the capital burdens of traditional letters of
credit (LOCs).
To make a
market in these OTC transactions, 20-30 financial institutions emerged and
largely adapted transaction-specific documents to template agreements sponsored
by International Swap & Derivatives Association (ISDA). Since ISDA contracts basically covered a
different class of trade for interest rate swaps and since various institutions
had internal policies dictating idiosyncratic practices, credit derivatives
trades were usually unique to the two counterparties. Use of ‘long-form confirmations’, scheduled
for replacement by reconfigured ISDA templates, entrenched the reliance upon
OTC trading. In ten years, credit
derivatives mushroomed to $60+ trillion
– as large as, or larger than, the global GDP – but were poorly documented
among market-makers via long-form confirms.
The
Current Predicament.
Largely unregulated, credit derivatives volume, as measured by notional
principal, dwarfed the actual principal amount at risk by third-party reference
entities. Additionally, bond insurers
entered the market by issuing one-off policies bound through special-purpose
vehicles. The multiples of notional-to-actual
principal suggested the existence of conditions conducive to a spiral. The London
reinsurance market (LMX) had already experienced just such a spiral (http://www.elbornes.com/index.php?section=articles¶m=19)
in the late 1980s, leading to significant insolvencies on the Lloyds
exchange. Though traumatic at the time,
this spiral was minor compared to the threat presently posed by the credit
derivatives market. In the LMX spiral,
reinsurers laid off exposures to each other, often over ‘hand-shakes’. Individual reinsurance loss limits were high
enough to divide into discrete layers for sale to retrocessionaires (i.e.,
reinsurers of other reinsurers).
Premiums remained rich enough for several parties to extract fees over
successive transactions.
Thus
reinsurers passed around the same risk several times over, eventually assuming
risk they had previously underwritten and then retroceded without realizing the
implications of doing so. This spiral,
when large catastrophe losses precipitated it, short-circuited the market and
concentrated insurance losses among certain reinsurers beyond their abilities
to indemnify, precipitating their insolvencies.
The credit derivatives market has created excess layers of coverage,
subject to an LMX-like spiral. Since a
credit derivative contract typically indemnifies the default of a reference
security, the terms of these not-quite-matching trades vary among the rapidly
trading counterparties; only a minority of trades – i.e., the core market –
involves end-users for actual credit exposures assumed. Speculators have also penetrated the credit
derivatives market in a search for profits from unexpected defaults or
turn-arounds.
In practice,
market-makers execute large volumes of off-setting trade at razor-thin spreads. Only recently have market-makers realized how
vulnerable they are to a collapse of what is appearing to be a house-of-cards
constructed on opaque financial transparency.
Market-makers have unknowingly – and negligently – re-assumed the very
risks they off-loaded just a few trades ago.
Like the childhood game of musical-chairs, the music has stopped and
frozen the market awaiting a credit indemnity spiral triggered by defaults of
reference entities. Downgrades of the
credit ratings of market-makers are forcing them to post collateral, imposing
large cash demands. Most of these
embattled market-makers are not insolvent (i.e., without the financial
nutrition of capital) so much as they are illiquid. Market-makers simply cannot convert their
embedded wealth to cash in a timely manner.
As with
humans, financial institutions succumb more quickly to the lack of water than
to the absence of food. The inability of
some market-makers to monetize illiquid assets has crippled them or hastened
their demise. Now the counterparties of
the increasing number of defunct or paralyzed market-makers no longer have
off-setting positions for some of their trades, requiring additional capital to
cover a contingent and unhedged indemnity payment; these unexpected burdens are
undermining the OTC market. Limited
interventions by the CBOT and others have slowed but not reversed this gradual
melt-down. With the hazards finally
identified and appreciated, the solution becomes straight-forward: stop the
spiral immediately; settle accounts; and, re-open the global market on a
manageable scale. The zero-sum game of
private competition precludes any one, or several, of the market-makers from
taking the initiative to extricate everyone from this predicament. A decisive, if short-lived, intervention by
financial services regulators remains the last option available to policymakers
in the countries domiciling these troubled institutions.
A Simple Solution but a Bitter Pill.
There are 20-30 market-makers in credit derivatives that dominate the
market, perhaps 80-90% or more of the of approximately $60 trillion of aggregate notional principal
valued on a gross replacement basis; or
$30 trillion of two-way
(i.e., symmetrically offsetting) trades.
The regulatory stakeholders overseeing these market-makers need to
convene a summit with them, as did the Federal Reserve a decade ago when
Long-term Capital Llc collapsed
ten years ago. These stakeholders must
mandate, through moral suasion or (if necessary) regulatory coercion, the following
actions:
- suspension of market-making activities pending a study by the stakeholders (essentially occurring right now);
- re-arrangement by market-makers of transactional data by reference entities, not counterparties, within 90 days;
- replacement of contract-specific terms by a universal definitions of credit events and standardized terms;
- netting out of exposures among market-makers by reference entities (not counterparties) with no differentiation recognized for unique contractual provisions (i.e., condense the spiral to the core market exposure);
- formation of a ‘best-efforts’ (i.e., not guaranteed execution) cross-border credit derivatives exchange supported by cash and capital commitments from market-makers with contingent indemnities by the regulators;
- transfer to the global credit derivatives exchange of contracts carrying more than $10 million of actual credit exposure insured with 100 trades;
- future trades to be executed from the exchange or subject to 30% LOC credit enhancement;
- mandate of market-makers to issue LOCs covering 30% of core exposure ineligible for transfer to the exchange;
- requirement of end-users to support net notional principal amounts of their credit derivatives portfolios with credit enhancement LOCs issued at cost by their market-making counterparties equal to 30% of principal insured; and,
- issuance by central banks of short-term credit support lines, extendible for up to five years, to support newly issued LOCs and facilitate the transition of the OTC derivative trades to the traditional banking products.
Exceptions to
be addressed include bond insurance policies for collateralized debt
obligations (CDOs); small transactions of market-makers ineligible for
inclusion on the proposed best-efforts exchange; and, exposures of non-market-making
financial institutions (principally end-users).
These exceptional exposures can be backed by LOCs issued by
TARP-supported or non-market-making banks supplemented by a second layer of
credit support from the central banks.
This structure will absorb all loss scenarios except for the
worst-case. For example, with this
structure, CDOs will be able to withstand a 30% or higher default rate followed
by losses principal in line with historical experience.
=======================================
The Honorable George
W. Bush
President; The United States of America
1600 Pennsylvania Avenue, N.W.
Washington, D.C.
20500
December 15, 2008
Attention Mr Henry Paulson; Secretary of the
Treasury
Re Proposed Solution to
Credit Derivatives Spiral
Gentlemen:
First of all, permit
me to wish you and your families’ holy days that are happy, joyous and free of
conflict. Secondly, I write you today
out of a sense of thankfulness for allowing me the privilege of serving my
country in Iraq
after my banking career. I would
appreciate your support in working with a provincial reconstruction team in Afghanistan.
The primary purpose
of this letter, however, is to make available to you a thought experiment That
is a pedantic way of saying an outline reflecting experience in banking;
strength in extracting actionable thinking points from volumes of information;
and hope that a shake-out / melt-down in the credit derivatives market is one
crisis we can avoid with relative ease.
Please refer to the two-page attachment that follows.
The current financial crisis – I prefer to
think of it as a set of challenges – emerged over years of policies and
practices, most of them sound. If there
is a crisis, it involves shoddy lending practices in a confined area of the
market, obscured for a time and profited by securitization, and a liquidity
trap created by fear. The mortgage
crisis, however, lies beyond my frame-of-reference.
Credit derivatives do
not; I became familiar with default-swaps, wraps and other grown-up
tinker-toys. This challenge has been
waiting to happen but need not graduate to a crisis level. The challenge is for you to take the
initiative, bring in the other powers participating in the recent financial
summit and exert American leadership in coordinating a uniform, highly coercive
but short-term regulatory response to re-structure this over-the-counter market
to allow it to digest and dispose of the overhang or exposure.
Successive trades
among market-making counterparties referencing the same risks have layered the
credit derivatives market with illusory exposure. What has happened in this market is that fear
stomped hard to deflate the financial soufflé created by this layered exposure;
the challenge remains not allowing the casserole dish (the underlying economic
foundation of the market) to shatter in the process.
As market makers net
out exposures based on the principal insured, credit derivatives will
rationalize into an organized options market for hedging purposes. The intervention basically imposes uniform
terms on over-the-counter instruments to permit this netting. Subsequent to that initiative, a
self-regulating cross-border market can function with a light touch from
government or international agencies.
President Bush, I
opened this letter by saying that I am writing you out of gratitude. It is also out of loyalty. Your work will come to be appreciated in
time. Your legacy will be strong. But there is a reason why Moses marched the
Israelites through the desert for two generations. Likewise, In Iraq and the Middle
East, such a gradual assimilation of new values will take
place. It had to start some time in some
way. You had the courage to do it.
If you interested in
my credentials for making the above-cited proposal, please contact me nedmcd@yahoo.com
and I will be happy to forward my résumé and a make a case why I can lead this
effort. Secretary Paulson, I hope you
find some of this thinking helpful.
Very truly yours,
Edward J.
McDonnell III, CFA
