Global Financial System – Calling for the Plumber!

Financial crises increasingly result from the structure of modern capital markets. External shocks – such as declines in housing prices – are transmitted via connections between participants who are tied together by complex chains of dealings. Concentration of trading amongst a small group of large dealers exacerbates the risk.

The decision not to support Lehman Brothers, with the benefit of hindsight, was a major miscalculation and a significant factor in the subsequent problems at AIG and other institutions as well as the complete failure of money markets.

Regulators and governments have shown limited appreciation of the detailed plumbing of the system for which they are responsible. In the present crisis, they have frequently appeared like Pritzker Prize winning architects trying to deal with blocked plumbing. Central bankers and finance ministers have found themselves in the position of Woody Allen: ” Not only is there no god but try getting a plumber of weekends.”

In fairness, even experienced professionals have struggled to understand the structure of modern markets. Jeremy Grantham, Chairman of GMO, recently observed: “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. And I have no idea, really, how this will work out. I certainly wish it hadn’t happened. 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.”

Increasingly it is difficult to analyse the solvency of financial institutions. The speed with which available liquidity and access to funding can evaporate renders financial statements out-of-date and inadequate.

Agreements such as those governing derivative contracts also increasingly affect solvency. For example, the downgrade of AIG below a “AA” rating triggered margin calls (in excess of $10 billion). The downgrade also gave counterparties to transactions with the firm the right to terminate certain contracts triggering large losses ($4-5 billion). AIG did not have adequate resources to meet these commitments ultimately requiring US government support.

The exact effect of financial distress depends on the form of any restructuring. In the case of bankruptcy, Chapter 11 filing or equivalent, the crucial issue is which legal entities are placed under protection. In the case of Lehman Brothers, only selected entities (primarily the holding companies) filed while other entities continued to operate. This means that the position of each institution dealing with Lehmans may be different depending on which legal entity they contracted with.

In the case of Washington Mutual (“WaMu”), the Office of Thrift Supervision closed the bank on concerns about its ability to meet its obligations. J.P. Morgan subsequently paid $1.9 billion to the Federal Deposit Insurance Corporation (“FDIC”), in its capacity as receiver, for the assets and certain liabilities of Washington Mutual’s banking operations. J.P.Morgan did not assume the senior unsecured debt, subordinated debt and preferred stock of WaMu resulting in losses for investors.

Financial distress inflicts predictable losses on creditors. In the case of Lehmans, creditors included banks from every continent – US, Europe, Japan, Asia and Australia. Retail investors in Asia and Europe who had purchased structured products issued by Lehmans also suffered losses.

Market estimates of recovery rates on Lehman’s debt are around 10-15% of face value (a loss to investors of 85-90%). Recovery rates will be affected by the nature of assets that many financial institutions now hold – private equity stakes, principal investments, hedge fund equity, complex slices of risk in structured finance transaction and derivatives. The difficulty in valuing these assets, their illiquidity and (currently) the absence of markets for many such assets may exacerbate losses.

If the financial institution files for Chapter 11 or bankruptcy then all derivative contracts entered into with the entity would also normally automatically terminate. This triggers a complex chain of events.

The value of the contracts must be determined by either seeking market quotations or other “commercially reasonable procedures” depending on the documentation. The values of individual contracts may be netted if the contracts specify to arrive at an overall amount that must be settled between the counterparty and the distressed entity. If the counterparty owes that amount then it must be paid immediately to the trustee in bankruptcy. This results in an immediate (possibly large) cash requirement for the non-defaulting party. If the distressed entity owes the amount then the counterparty must lodge proof of debt with the bankruptcy trustee and await payment.

If the counterparty is holding collateral securing the exposure under the contracts then the collateral must be sold to realise cash to cover the amount due.

Where the derivative contract was being used as a hedge, termination of the derivative contracts exposes the counterparty to the underlying risk. The counterparty must then enter into new contracts at current market prices to re-hedge itself to avoid additional risk. Hedging must generally be done on a contract by contract basis with limited scope for netting.

The entire process is complex and time consuming meaning that the amount of losses sustained may not be known with certainty for some time.

A bankruptcy or Chapter 11 filing may also trigger contracts referencing the financially distressed firm. For example, the bankruptcy filing would have triggered such as credit default swaps (“CDS”) contracts on Lehman Brothers requiring settlement of these contracts as well.

Where CDS contracts were held as hedges they would alleviate losses that would otherwise have resulted. In all cases, settlement triggers payments creating potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehmans totalled around $365 billion. If a party is unable to meet its obligations under a CDS on Lehmans then the process starts over again involving the new party.

Financial distress affects other parties through “contagion”. Counterparties who had dealings with the distressed entity either suffer losses or suffer cash outflows as they meet termination payments. They may suffer additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality and solvency setting off falls in the price of their shares and rises in borrowing costs. If credit ratings are affected then this may trigger margin calls or other events that further threaten solvency.

Financial distress of any entity also affects the market. Volatility of asset prices increase reflecting liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity is reduced as the number of counterparties falls. Credit limits become scarce limiting the ability of firms to deal with each other. Uncertainty about the impact of financial distress of one entity on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms. Asset price falls trigger further cash calls and distress for other market players.

The process is complicated by a variety of factors. In any bankruptcy, the sheer number of contracts that must be dealt with can be large. Lehman Brothers, it is understood, had about 2 million contracts open. There are likely to be cases of incomplete documentation and errors that will need to be resolved. Operational risks and problems of logistics abound.

The bankruptcy proceedings inevitably accelerate the need to deal with difficult to value and illiquid assets. Action taken by the trustees and administrators in the best interest of creditors can adversely affect the overall market.

Bankruptcy law is jurisdiction specific and different sets of trustees and administrators will grapple with how to best manage the assets of a specific legal entity for the advantage of its creditors. In the case of Lehman Brothers, there are already disputes about transfers (totalling $8 billion) made between the English entity and the US companies. There may also be differences in approach in dealing with the assets. The US trustee in bankruptcy indicated that “time was of essence” in dealing with the assets. In contrast, the UK administrator anticipated a long drawn out affair. All this creates uncertainty about the impact on creditors and the market.

Assets held in a fiduciary capacity can become entangled in the process. Where Lehman Brothers acted as prime broker, hedge funds and other asset managers now face a cumbersome process and potentially lengthy delays in recovering investments held by Lehman. This affected around $45 billion in assets and $20 billion in short positions. The legal owners now are unable to deal with their assets but may face margin calls if the value of the positions deteriorates.

The true owners of these assets also become exposed to risk of losses where their assets (pledged to cover loans) have been re-lent by Lehmans to finance itself (a process known as “re-hypothecation”). This spreads the problem to hedge funds and asset mangers with no ostensible exposure to the bankruptcy.

These complex networks and links tie to together all participants in modern financial markets. The chains of risk spread problems from distressed financial institutions to weak institutions ultimately affecting even strong entities, seemingly remote from the problem.

The risk spreads through direct losses, calls on liquidity, the ability to fund or the uncertainty created that ultimately brings the ability to deal with confidence and security in financial instruments to a halt. Contagion resembles nothing so much as a hungry wolf pack that systematically hunts down weakened prey animals within a herd one by one.

Understanding of the detailed connections, whilst unglamorous, is increasingly the key to anticipating the evolution of the crisis and preventing exposure to events. It is also where long-term reform efforts of the financial system 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 exacerbating its risks.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management include Swaps/ Financial Derivatives Library – Third Edition(2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), described by the Financial Times, London as “ fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry“. He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland).

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.

14 Responses to "Global Financial System – Calling for the Plumber!"

  1. Anonymous   November 25, 2008 at 2:54 pm

    Sounds complicated. I appreciate your explaining these risky entanglements.

    • jbucher   November 27, 2008 at 9:29 am

      This article is on to something, but hardly enlightening. The implicit point has something to do with the complexity of the financial system. What is the answer? More easy credit? That was the problem. The solution is better financial management by changing incentives of the managers, but right now more regulation with stymie the system with even more complexity.This may be the end of central banking. Look at inflation in the U.S. over the last century and and compare to before. The only way to find out is to back out of the current system, slowly and prepare the path to currency privatization through a gold standard.

  2. Guest   November 25, 2008 at 10:47 pm

    Humble thanks, Satyajit. derivative mentality meets chaos reality.

    • Guest   November 27, 2008 at 9:47 am

      There is no plumbing in a real free market. This is the conceit of the author who should consider the Austrian perspective here that see the market as a process and not a system. Capitalism is an antiquated term of Marxism.What is the “shoddy” monetary philosophy at work here?Hayek and other Austrians had the answers, but no one would listen to them. Free banking is the answer.

  3. DocBerg   November 25, 2008 at 10:56 pm

    Since the free market is obviously dead, I see no reason that further interventions in the financial arena should not be in the form of anti-trust actions. If a firm is too big to fail, then obviously it should be broken up enough to ensure that it can go belly up with minimal consequences to the economy at large. I realize that since at least the panic of 1909, the national government has been, to paraphrase Honest Abe, Of the bankers, for the bankers and by the bankers. This has resulted in too much concentration of power in banks, especially those in New York City. This has resulted in the repeal of workable restraints on greed such as Glass-Steagal. Cartels such as the Federal Reserve need to be broken up as well. It took more than a thousand years to abolish serfdom after the Fall of Rome. Why should freemen be put back into this dismal state just to bail out a bunch of greedy cretins? How long will it take to abolish it now?

    • Guest   November 27, 2008 at 9:39 am

      The free market isn’t dead. It’s broken and needs a vacation before real reforms can take place. When one corporation is given absolute control over the world currency, you cannot call the system that evolves in its midst free market. To have a real free market, you must have private currencies that compete in the global financial system.Central bankers and their economist brethren are not omniscient gods as most people assume. They get it wrong most of the time, because the international markets are too complex for any one person or group of people to understand. This leaves markets and the individuals acting within them vulnerable and somewhat irrational.In the new world of near-perfect information, there is no need for central banks. Information systems that should be built in the wake of this crisis will assess market risks better than ever before, leading the way to the dismantling of currency monopolies.Once the dollar is dead and buried along side the Euro and the rest, we will have a free market. Until then, we are still serfs beholden unto a league of extraordinarily arrogant men who think they are capable of managing chaotic systems known but to god.

  4. Dr. Crow   November 25, 2008 at 11:21 pm

    Absolutely brilliant synopsis of what’s gone wrong and why it can continue to do so. Thank you so much for the lucid and enlightening read!

  5. Guest   November 26, 2008 at 2:32 am

    very insightful

  6. Mike G.   November 26, 2008 at 2:43 pm

    The solution is transparency and regulation.

    • Guest   November 27, 2008 at 9:31 am

      Regulation is the antithesis of transparency.

  7. Kiers   November 27, 2008 at 7:11 pm

    A small tax implication too, Mr Das:Companies that file Ch. 11 and are liquidated, lose all their tax loss carryforwards. Any new entity absorbing those assets must start paying taxes from then on!The American Treasury is being nasty here, they are protecting and allowing to survive: trades in DERIVATIVES, they continue to evade transparency about what’s on the books of these bailout recipients with elite impunity, and the sheeple could care less!What rubbish has gone on here for the last 10 years:1) Dot Com Bubble,2) Telecom Bubble,3) Commodity Bubble,4) Real Estate Bubble,and5) now…BAILOUT BUBBLE.Where are the elite economic historians?What is the REAL AGENDA? Sink China? Launder Drug Money flows? What’s going On? Don’t talk to me about tulip mania!! 5 Bubbles in 10 years is PSYCHOTIC!

  8. plp15   November 29, 2008 at 7:47 am

    Thank you, Mr Das, for illustrating so clearly how these creative financial instruments work. While these instruments have facilitated the creation of huge amounts of liquidity (which has now gone away!!), your discussion demonstrates that these instruments have made, and will continue to make the whole system unstable.Yet I do not see anyone, not even Martin Wolf, in his FT article “A time for humility”, where he addresses some of the shortfalls of Economics, addressing this as a problem.Surey correcting this instability is part of the solution? Isn’t this one of the underlying factors in the reluctance of Banks to return to “business as usual”?

  9. Guest   December 3, 2008 at 10:59 pm

    “participants who are tied together by complex chains of dealings””These complex networks and links tie to together all participants in modern financial markets”Brings to mind: Anne Hathway had a ‘boyfriend’: Follieri, age 30 (now in Fed Prison). Said Follieri, while peddling real estate investments, knew and fraternized with (in the space of 3 years)…Bill Clinton, Cardinal Egan, John McCain, Ron Burkle, Bernie Kerik, Cindy Adams, Susan Shin, Cardinal Angelo Sodano, Vincent Ponte, Pope John Paul 2, Douglas Band, Marty Edelman, Carlo Slim, Oscar de la Renta, Hillary Clinton, Mikhail Baryshnikov, Michael Cooper, Roberto Cavalli, Carmella Santucci….The MORAL of the story: MONEY is fungible, and it TRAVELS.

  10. Nicholas Drew   May 16, 2013 at 9:28 pm

    Nothing to worry of contacting a plumber because in los angeles plumbing repair services will socially help you for the sake of the management will not be argue.