September 27th, 2008

Derivative Obligations:
Oh what a tangled web …

Posted in Money by ed

Ed Note: See comments below for updates on the themes sounded here across subsequent days and weeks into October. The cruelest month.

Very good overview in the Times of how credit default swap agreements got out of control at AIG.

Lehman, however, is/was in the same pickle — and the air in the Times story that the world just barely missed stepping off the cliff here is misleading.  The bankruptcy of Lehman is pulling the world apart by the seams.

1.  The culprits at Lehman are very much as described by the Times at AIG:  a zillion outstanding swap agreements entered into by supposedly sequestered “specialty financial products” subsidiares (e.g., Lehman Brothers Special Financing, Inc.) — which swaps, however, were guaranteed in side letters by Lehman Brothers Holdings Inc., the corporate parent.

While AIG, an insurance company, seems to have focused on providing bond “insurance” by acting as Protection Seller in credit default swaps, Lehman, a broker-dealer, was more focused (in my experience drafting deals for them) on issuing not only mortgage bonds (Bread and butter, bread and butter …) but CDOs and similar as problem solvers for particular clients.  (See What is a CDO? (I mean really).)

But every CDO and CMO I’ve ever cast eyes upon was festooned with swap agreements:  Interest rate hedge swaps. Interest cap swaps. Perhaps credit default swaps on assets in the CDO pool, or on collateral appended as “credit enhancement,” to sweeten the deal …

That is: the versatility of the ISDA swap agreement means it can be used to solve just about any problem — to bridge any gap between a hustling young so-called banker trying to close his first or second deal and the intended buyer(s) of the bonds produced by a securitization.

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2.  Three or four years ago my boss and I wondered aloud for a while what would ever happen if a Credit Event struck Lehman — thereby triggering termination of these zilion swaps.

Here’s an answer, from a prominent Wall Street law firm.

“Credit Event”?  E.g., a reduction in its long-term credit rating, for example, by Moody’s or S&P. Just a notch or two would do it.  Never did we contemplate the parent’s bankruptcy.

3.  This I think is what’s behind Bill Gross’s call Friday for the Fed to step up and act as a “clearinghouse” to “unclog the pipes” of the financial system.

That is: Simply because of the Lehman bankruptcy there are counterparties worldwide holding the bag on a zillion busted swaps — and in most cases probably in deals that until the bankruptcy filing were healthy.

E.g., a diversified CDO.  Where mortgage bonds comprise no more than 3 or 4% of the assset pool (as was often the case in deals I drafted most of this decade). Credit card bonds 10% or 20%. Maybe no auto loan bonds at all. No Manufactured Housing loans.  Half the pool in well rated corporate bonds.

Ie, a diversified pool of bonds and similar most of which were likely still performing when Lehman made its filing.

Disaster has now struck such deals, as the swaps that were built in to protect the investors (against, eg, big interest rate swings) have had their termination provisions triggered by the mother of all Credit Events (the guarantor-parent’s bankruptcy) — and thus money is due from Lehman but not forthcoming — and so the CDO itself (it says here) has to be wound up — which means selling the vast pool of bonds — into the worst credit markets we’ve ever seen.

In most deals probably no one wants to do that — neither the Lehman bankers nor the trustee with fiduciary responsibility for assets nor the portfolio manager nor the tranche investors.

So working something out — by bushwacking beyond the confines of the deal contracts — until the chaos subsides … This I imagine is what Mr Gross had in mind when he called on the Fed to function as a plumber and a clearinghouse.

(Something like this occurred when Delphi auto parts went under ca 2003 (if memory serves) and the world discovered a universe of swaps — now triggered by the collapse — that could not be settled by their own terms. What to do? The big boys got together and worked things out.)

4.  Everyone says (could be wrong) that the weekend before Lehman filed bankruptcy, the CEO, Richard Fuld, gave the finger to his crocodile suitors offering dimes for dollars.  (Primarily, Barclays of London — which since has been picking the carcass clean.)

Lehman at that moment was struggling to get delivery on a $17 billion line of credit with JPMorganChase — which had consumed Bear Stearns in March with $29 billion in aid from the Fed.  Now, as Lehman floundered, JPM refused to put the $17 billion in the mail.  (Lehman shareholders have since sued JPM.)

Fuld, in telling Barclays no deal, perhaps was relying on the JPM credit line and the history of fed intervention with Bear Stearns.  In any case, by arriving at Monday morning with no deal done, he in effect challenged Paulson and Bernanke: Go ahead, I dare you. Let us fail.

And Paulson called the bluff.  And Fuld filed bankrupctcy.

But, a day later, as the Times article makes clear, AIG in the same position dragged Goldman Sachs (which Paulson not long ago chaired) to the precipice. And Paulson blinked.

Or was it a wink?

That’s the piquant question — which the Times piece clearly alludes to.

But … There plenty more pressing questions at the moment on the table.

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When one steps back to comprehend the wreckage of the Bush-Cheney years ….

Enron, Lehman, AIG, no doubt others, all involve, mechanically, a network of obligations entered into at outposts along the corporate periphery manned by young hustling so-called bankers or account executives, but which lead by circuitious roots to the parent.

In Enron it’s clear that criminal intent was involved in masking the public tallying of those obligations.  I haven’t seen anything yet to suggest same at Lehman or AIG.

Rather:

– Ecstatic greed by the hustling young looking to be millionaires before their 30th birthdays.

– Blinding greed and laxity by senior managers overseeing the hustlers’ deals.

– Misplaced faith in the parent’s ability to handle its many splendored obligations, based in part on ignorance and willing blindness but also on

– professed faith in spreadsheet models that failed to predict high-stress (non) performance of MBS, CMOs, CDOs, etc. — in many cases (as already discussed in the press) because the models were tweaked to be forgiving … by hustling so-called bankers … and so-called senior managers … yadda yadda yadda …

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13 comments

  1. ed says:

    WSJ reports QUOTE:

    “… a broad range of borrowers, not just mortgage holders, are now starting to default on their debt.

    “For instance, about 2.4% of payments on credit cards are more than 90 days overdue, according to the Federal Deposit Insurance Corp., the highest level since 1991.”

    END QUOTE

    Ouch. I’ve been waiting for this.  (Told some friends a year ago:  “When you start seeing stories about credit card bond failures, hit the deck.”)

    Why is this such bad news?

    Because credit card bonds are/were the gold standard — and often used as “secure collateral” to underpin riskier financial investments.  (See the third example in this article.)

    The world does not want credit card bonds to tank.  I have no idea how they trade right now (I imagine poorly).  But … Oy.

    The simple fact is:  Everyone everywhere is holding paper the early termination provisions of which have been triggered.  But the utter lack of a credit market means winding up the deal is at best a losing proposition and at worst not physically possible.

    Thus again — Bill Gross’s comment (in the post above) about the Fed acting as a plumber and clearinghouse is key to any hope of stopping the madness.

    September 28th, 2008 at 8:11 pm

  2. ed says:

    Here’s Paul Krugman highlighting the ill effects of Lehman’s bankruptcy.

    October 4th, 2008 at 12:40 pm

  3. ed says:

    Hmm. The plot thickens as to how and why Lehman went under.

    Financial Times reports that in July Lehman petitioned the Fed to be converted into a bank holding company (thereby gaining access to more Fed credit).

    In September the Fed did this — post Lehman bankruptcy — with Goldman and Morgan Stanley, to help them survive as stand-alone entities.

    But in July the Fed refused Lehman’s petition.

    So now we have both the Fed and Paulson (item 4 in post above) giving Lehman the finger as it swirled down the drain …

    … dragging global finance along in its vortex.

    Stuff of a Grisham thriller fer sure.

    October 6th, 2008 at 11:03 am

  4. ed says:

    Here is Tony Crecenzi (excellent credit market watcher) elaborating on the “clearinghouse” function he and Bill Gross (in post above) hope the Fed will soon adopt:

    Another Fed Step: As Clearinghouse

    By Tony Crescenzi
    RealMoney.com Contributor
    10/6/2008 11:59

    One solution to the confidence drought is for the Fed and other central banks to announce that they will act as clearinghouses for regulated banks and securities firms for exchanges of cash-for-collateral.

    The Fed would take on a role often performed by large banks operating in the so-called tri-party repo market, wherein banks act as a go-between between counterparties.

    In a tri-party repo, banks not only know both sides of a repo transaction, they also hold the collateral put up by the dealer or bank seeking cash-for-collateral.

    Trust has broken down so severely that only the Fed and other central banks can restore it, it seems.

    The main goal in having the Fed act as a clearinghouse would be to reduce or eliminate any fear that counterparties might have in dealing with each other.

    There is very little risk to the Fed in acting as a clearinghouse because the securities pledged in tri-party repos are free from any third-party lien, charge, or claim.

    Any securities the Fed takes in would be segregated from other securities that the Fed might be holding.

    October 6th, 2008 at 12:13 pm

  5. ed says:

    Re billions of early-termination triggered derivatives:

    Todd Harrison at Minyanville.com notes that today, Monday October 6 — with the Dow 30 down 675 at the moment after aforementioned quasi-crash in Europe:

    QUOTE

    we’ll receive word from the International Swaps and Derivatives Association (ISDA) regarding the settlement of credit derivative transactions in Fannie Mae and Freddie Mac.

    How this protocol plays out will reverberate throughout the entire Credit Default Swap universe.

    In plain English, there isn’t enough money to go around and counter-party risk has increased in kind. Whether or not that can be contained will go a long way in shaping the next leg of the tape.

    The government is keenly aware of these developments.

    They woefully underestimated the amount of short-term Lehman Brothers paper held in money market funds—which contributed to the panic when some funds “broke a buck”—and explains why they’ve been more careful in how they’ve since handled situations, keeping both AIG and Wachovia alive while allowing WaMu, with little short-term debt, to fail.

    END QUOTE

    October 6th, 2008 at 1:29 pm

  6. ed says:

    Dick Fuld, the Lehman chairman (see item 4 in post above) is confessing sins before Congress today.

    Here’s a withering blast from a pretty good Wall Street pundit.

    Apparently the WSJ yesterday published an account of what Lehman’s books really looked like. Garbage.

    Eg: Marking commercial mortgage bonds at near par (a dollar) when the average across the Street was 65 cents.

    October 7th, 2008 at 10:48 am

  7. Omerta says:

    So Ed,

    Looking at the sytemic effect of these instruments and their prevalance. It would appear to untrained eye that they whether they did or did not anticipate trigs, their systemic effect is to insure “the system” against triggering events because they generate so much uncertainty and counterparty risk that they a large enough trig event will bring on at least the symptoms of systemic risk.

    In addition they appear to be senior claims to everything else, thus triggering subordination of all other claims.

    Is this right?

    October 9th, 2008 at 6:26 am

  8. ed says:

    I’m sorry to say I don’t understand what you wrote in the first paragraph.

    (Do you mean that persons unknown went about filling the universe with structured finance bonds as a kind of Doomsday Machine?)

    In your second, I don’t know who/what “they” (third word) refers to.

    If “they” are the zillion swaps LBHI guaranteed in a half zillion deals still outstanding — which now have at least technically had their Early Termination provisions triggered, then …

    Does that mean the “other claims” you refer to are those of Lehman’s other creditors?

    Presumably ALL of Lehman’s creditors are seething in the street outside the Bankruptcy court. The latter will now decide who gets what before whom, pretty much.

    I have no idea where in that morass the issuer of a CDO that has an interest rate hedge provided by Lehman might stand. “It goes as it goes — Danaans and Trojans have it alike.”

    October 10th, 2008 at 6:55 pm

  9. ed says:

    The mass, bushwacking ‘auction’ today to determine the settling values of all the outstanding credit default swaps targeting Lehman came off with a very low/high result.

    The Protection Sellers will be paying over 91 cents (out of 1.00) for every subject Lehman bond.

    Estimates are that the dollar cost paid/rec’d will be about 270 billion.

    Big diff. More.

    October 11th, 2008 at 1:45 am

  10. ed says:

    Here is an account of how lax — to the point of being empty — the British securities laws were/are.

    And how this made the impact of Lehman’s bankruptcy all the more horrendous over there.

    October 19th, 2008 at 9:12 pm

  11. ed says:

    Update on the Great Unwind of Lehman:

    The Independent (in Britain) today sadly sighs that Lehman’s bankruptcy is ten times more complicated than Enron.

    November 15th, 2008 at 10:49 pm

  12. ed says:

    Here from November now is a Times overview on continuing declines in housing prices and sales that almost leads by blaming the enlarged crisis on the Lehman bankruptcy.

    November 26th, 2008 at 6:43 am

  13. Quincy Galuszka says:

    Thank you for another excellent article. Where else could anyone get that type of information in these kinds of a perfect way of writing? I’ve a presentation next week, and I’m on the look for such details.

    February 15th, 2011 at 6:32 am

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