Archive for the ‘derivatives’ Category

The details of the write-down of Greek debt are set, or at least set conditionally, it will be very interesting to watch how the markets respond.  On the details, this figure sets out the timeline and how market/debt-holder participation influences the process.

After all this time and European money, a flat out default is still quite possible.   And it is also interesting to note that the structure has not solved the free-rider problem or the CDS problem.  Some debt holders may not accept the terms of the restructuring in the hope that others will be restructured and they will be paid in full.  This problem may bring the whole structure crashing down.  Some investors may have debt which is written down by more than appropriate for its term (e.g. long-term debt holders taking very severe write-downs or short term debt holders taking even modest write-downs).  The CDS problem is that insurance creates moral hazard.  The decision-maker for any given debt instrument may not have an interest in maximizing the payoff of the debt and may instead prefer full default or a differently structured write-down (or even be over-insured and benefit from a complete default).

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The New York Times today brings a story I missed: The CMEGroup has ended trading in futures on frozen pork bellies. This does not mean that the US has stopped eating bacon, produced from pork bellies. As you can see here (from the USDA), the US each week consumes more than a pound of pork per person. Moreover, the CME continues to trade lean hogs futures. It seems instead, that there just isn’t much demand anymore for frozen bellies.

The term “pork bellies” had a gritty, mythic resonance, redolent of the city of big shoulders, hard labor, slaughterhouses, and the frantic screaming and jostling of trading pits. By contrast, this is the era of sleek air-conditioned trading floors and deconstructed BLTs.

There will never be a flash crash in a pork belly.

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An interesting aspect of the European rescue plan for Greece is that the ISDA (the International Swaps and Derivatives Association) ruled  that the restructuring was not a credit event for the purpose of settling credit default swaps. ISDA’s rationale is that the restructuring was voluntary — if you want to continue to hold unrestructured Greek debt, you can. Nevertheless, many bondholders will have a financial experience equivalent to a default; they will take a writedown on their debt, accept lower coupons, and have a guaranteed principal payment.

Probably a goal of the rescue was to avoid creating a credit event. There were fears that an official Greek default would cause CDS sellers to fail (remember AIG?), in which case CDS buyers (such as banks) who thought they had hedged their Greek government bond positions would not have been hedged, and this could have caused a cascade of failures. It’s hard to know if this was a plausible scenario, but this time at any rate, we won’t have to find out.


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Finally, the two parties have agreed on legislation that largely ends “too big to fail.”  The latest amendment to the financial reform legislation, sponsored by Senators Dodd and Shelby, is described by Dodd here.  My view is that this amendment does end too big to fail and dramatically reduces taxpayer exposure to large failing financial firms. The legislation allows large financial institutions to be taken over and run and liquidated in an orderly fashion by the government when they become insolvent. All shareholders and creditors will take losses in proportion to what they would have taken had the firm been allowed to fail.  It limits section 13(c) of the Federal Reserve Act so that the Fed can only use its emergency lending to lend to solvent institutions (My understanding was that this was pretty much the Federal Reserve’s interpretation of their authority during the initial phases of the crisis and that this interpretation is why Lehman was allowed to go under.  However, as the crisis evolved post-Lehman, the Fed relaxed its interpretation because the size of the “emergency” made the strict interpretation of “lending” as opposed to bailing out less relevant – see Maiden Lanes I through III.)

My two concerns? The legislation seems to be a field day for lawyers in the wake of any such failure.  I would prefer legislation that requires such institutions to have covenants in place ex ante that specify relative losses across debt classes when an institution fails. Second, I fear the complete stripping of an institution before it goes under, which would leave all creditors and equity with nothing but potentially leave the government either needing to cover some of those losses which “somehow” appear to be held in systemically important places or having to cover some commitments of the defunct firm to maintain faith in the financial system. This is related to my view that derivatives contracts allow firms to make new debt senior to existing debt and to pledge value out of firms ‘expropriating’ long-term debt holders and now potentially the taxpayer. Your thoughts are welcome . . .

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Here is an excellent piece on the likely Greek default by Marty Feldstein. A great topic in the hands of a great economist who writes clearly.

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On April 20, David Letterman read the Top Ten Goldman Sachs Excuses.  Oddly, the list includes all three of Goldman’s main arguments against the SEC charges.  See if you can guess which three (answers below):

(Link) Tuesday, April 20, 2010
Top Ten Goldman Sachs Excuses


9.You’re saying “fraud” like it’s a bad thing

8.Planned on using money to buy everyone in America delicious KFC Double Down sandwich

7.Distraught over George Lopez’s move to midnight

6.We were framed by evil menswear company Goldman Slacks

5.Since when are financial institutions not allowed to screw their customers?

4.Hey sport, how much to make these questions go away?

3.America needed a villain both Republicans and Democrats can hate

2.Everyone we ripped off got an “I Got Cheated By Goldman Sachs” tote bag

1.Uhh, it’s Obama’s fault?

Answers: 9 and 5 (and a little 10).  Seriously.  The defenses so far center around the idea that not disclosing that short interest selected the mortgages to put into this particular synthetic CDO deal was not illegal. The argument is that their customers should be aware that they may be trying to screw them. And the company seems to be fine with what happened, as long as they were making a buck without doing something illegal (yet to be determined of course).

Question: what is better for Goldman, 1) claiming this was a terrible mistake, that Goldman seeks to always disclose any and all pertinent information to clients, and that the company will build stronger internal safeguards to protect its clients, or 2) the current strategy?  Question: what is better for America?

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The Senate Agriculture Committee just passed a bill regulating the derivatives market. Summary here. The legislation imposes clearing and trading requirements and real-time reporting of derivatives trades. It provides exceptions for some businesses like electric cooperatives which have argued that hedging business risks are important. It also tackles the moral hazard problem that the possibility of bailouts creates. (That is, if banks feel that the government will bail them out when they lose money, they take more risks since the downside is smaller for them). If the bill becomes law, the Federal Reserve Board and the Federal Deposit Insurance Corp. will be prohibited from providing any federal funds to businesses who are involved in derivative deals. This seems to imply that banks engaging in naked swaps transactions would have to spin off their swap dealer desks or be out in the cold in a crisis when others might be receiving bailouts. Of course, in a  crisis, laws change, and if no one spins off their desks, we are unlikely to let all banks go under (see Fall 2008).

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