Derivatives

  • 14 May 2013 at 3:06 PM

Actually Lehman’s Bankruptcy Worked Out Well For A Lot Of People

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Bloomberg has a fantastic article today about how Lehman’s decaying corpse is suing a bunch of former clients, many of them wee and sympathetic nonprofits, who hosed Lehman when they terminated swaps in September 2008. Some of these lawsuits turn on disputes over when those clients, or their consultants, should have valued the swaps for termination purposes, and I was looking forward to reading Bloomberg’s account of which of those customers used the SWPM <go> function on their terminals and on what dates, but for some reason that wasn’t mentioned.

The basic story is that clients had trades with Lehman that were in-the-money to Lehman, and when Lehman went bankrupt the clients terminated the trades and wired Lehman termination payments that Lehman now rather belatedly finds inadequate. You could understand why the clients would want to get out of these trades: for one thing, the trades had moved against the clients (thus being in-the-money to Lehman) and seemed likely to move further against them1; for another, if the trades did move back in the clients’ favor, what were the odds that a freshly bankrupted Lehman would pay the clients what they were owed?

Is Lehman right that the clients underpaid? Oh, I mean, of course. I don’t have the details of the trades but you can reason this out from first principles. Here:

  • It’s September 15, 2008, and Lehman has just filed for bankruptcy.
  • You owe Lehman some money.
  • How much you owe them is a somewhat subjective matter that depends on what termination date you pick, what model you use, whom you ask for a quote, etc.
  • You know, with some certainty, that everyone at Lehman who knows anything about your trade, and also everyone who doesn’t, has bigger things to worry about, like stealing office supplies on their way out the door.
  • You can basically write them a check and enclose a note saying “here’s what we think we owe you,” and see if they write back.
  • How big is the check?

Read more »

  • 02 May 2013 at 12:09 PM

Lehman’s Bankruptcy Worked Out Well For Intel, Anyway

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One possible reaction to Apple’s gigantic tax-optimized share repurchase program is to think that spending a lot of time fiddling with how to optimize your share repurchase program might mean you’re out of better ideas. You can ponder whether this Intel share repurchase trade described in a Lehman Brothers bankruptcy lawsuit filed yesterday supplies any evidence on that question. Intel decided to buy back $1bn of its stock in August and September of 2008, and rather than just buy it in the market it entered into a pretty fiddly forward contract with Lehman like so:1

  • Intel gives Lehman $1bn on August 29.
  • Lehman hands the $1bn back to Intel for safekeeping – it’s Lehman’s money, but Intel keeps it as collateral.
  • On September 29, Lehman gives Intel some shares, based on the average price of Intel stock from August 29 to September 26.2
  • The dollar amount of shares Intel buys is $1bn, if the average price is $21 or below, or $250mm, if the average price is $25 or above, or some amount linearly in between if the average price is between $21 and $25:

  • If the dollar amount Intel buys is less than $1 billion, Lehman gives back the extra money.
  • So in other words as the stock price goes up Intel buys fewer shares, and vice versa, which is kind of wrong-way for them3 but right-way for Lehman.
  • In exchange for that risk Lehman agrees to give them a discount of 10.6 cents per share.4
  • The number of shares Intel buys is equal to the dollar amount divided by the average price minus 10.6 cents:

Read more »

  • 01 May 2013 at 3:34 PM

Bart Chilton Can Solve CFTC Funding, High-Frequency Trading Problem In One Fell Swoop

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If Congress won’t act to curb derivatives speculation (and fund his own agency) with a transaction fee, Bart Chilton will. Read more »

  • 26 Mar 2013 at 5:42 PM

ISDAt Wrong?

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The European Union will be very cross if it finds out that the International Swaps and Derivatives Association conspired with its members to keep out would-be members. Read more »

  • 22 Mar 2013 at 1:20 PM

Everybody Wins With Bespoke Synthetic CDOs

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Bloomberg this week had an article about how bespoke synthetic CDOs are coming back in vogue, and various people have fretted about that, because synthetic CDOs are scary, financial crisis, etc. And, sure, it’s certainly possible that the next financial crisis will be exactly like the last, only with more Cyprus.1 But today let’s talk about something tangentially related.

If you require banks to have capital based on risk-weighted assets, and if capital is expensive (at least for bankers), then you’ll have banks who want to lower the risk weights of their assets. There are many ways to do this, including buying safer assets, selling riskier assets, monkeying with models, etc., but one popular way is to buy credit protection against risky assets. The reason that this is popular is because of regulatory discontinuities: if you have $100 worth of stuff with a 200% risk weight, then you have $200 of risk-weighted assets, but if you buy protection against the riskiest $10 of it then you might go from $200 of risk-weighted assets all the way to $6.30, because the safest $90 of it might have only a 7% risk weight.

That’s a big jump. If your aim is to have capital equal to 12% of your risk-weighted assets, then your capital requirements go from $24 to like 75 cents. If your cost of capital is 10%, then that jump saves you $2.32 a year. So you could pay, say, $2 a year to the protection provider and still be up a few cents, versus not buying credit protection – plus, of course, you’ve got credit protection (meaning that you get more money back if there are defaults). And if you pay $2 a year for five years to protect $10 worth of risk, then the protection provider should do that trade all day long: he’s getting paid $10 to take $10 of risk. At worst – if 10% of your stuff, or for that matter all of your stuff, defaults – he breaks even. It’s free money.

That’s oversimplified (time value, counterparty risk, whatever), but it’s kind of a thing. To some extent that thinking underlies things like the glorious Credit Suisse PAF2 trade, where Credit Suisse basically wrote credit protection to itself because doing so saved it so much on risk-weighted assets. But the folks on the Basel Committee on Banking Supervision don’t particularly like it, and so they released a document today yelling at banks about it. Read more »

  • 12 Mar 2013 at 10:42 AM

Derivative Of Derided Derivatives In The Works

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So credit-default swaps have a pretty bad rap in the wake of that whole financial crisis. And people apparently aren’t interested in trading things that some parts of the general public (otherwise known retail investors) blame for the aforementioned unpleasantness without actually understanding anything about CDS.

The IntercontinentalExchange has an idea to change all of that: Sell them that which they do not understand. Read more »

  • 27 Feb 2013 at 1:23 PM

Mourn For The Derivative On Its Derivatives That Credit Suisse Wrote To Itself

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You may not believe this, but a few weeks ago I spoke to a business school class about the financial industry, and a student asked me “what would you say to someone who’s considering a career at an investment bank?” Somehow it did not occur to me to congratulate her on her humanitarian impulses. Instead, I suggested that there are two possible futures for the big banks. In one, the various efforts to “make banking boring” – more onerous capital and liquidity regulation, clearing and futurization of derivatives, bans on prop trading, calls to break up big banks, and so forth – would create amazing opportunities for people with the intelligence, motivation, and shall we say aesthetic sensibilities to find new ways to accomplish their non-boring goals within a shifting framework. Just like changes in the tax code create work for smart tax lawyers, so changes in banking regulation and structure create opportunities for smart bankers to steal a march on their competitors.1

In the other possible future, banking would be boring.2 Today is a dark day: Read more »

  • 07 Feb 2013 at 7:13 PM

If You Tax Derivatives, Only Derivatives Will Pay Taxes

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In general when something is headlined “A Sensible Change in Taxing Derivatives,” or “A Sensible Anything,” that’s a good sign that it’s not; things that are sensible don’t have to advertise. Also: ooh derivatives are evil ooh, so the odds are even worse. But this particular sensible change – a Victor Fleischer DealBook column about a Republican House proposal to tax derivatives on a mark-to-market rather than “open transaction” basis – is more sensible than you might initially expect; it’s mostly plausible and inoffensive and non-pitchforky.1 (The idea is straightforward: if you own a derivative, and it went up in value this year, you pay taxes on the increase in value. Unlike with, say, stock, where you only pay taxes on the increase in value when you sell the stock.)

One way to tell it’s not too bad is that various reports suggest that the Wall Street reaction so far has been “meh?” or “huh?”; this is presumably in part because it’s not clear how real this is and in part because it’s not clear how bad it’d be if it was real. Wall Street, in the sense of derivatives dealers, already pay taxes on their derivatives inventory on a mark-to-market basis, so the dealers’ dog in this fight is not their own taxes but rather the marketability of various products, from boring ETNs to lovely variable share forwards, to customers focused on tax efficiency.

Nonetheless! There are two ways to think of derivatives. One is they are a specific class of evil things, often involving acronyms, designed to let banksters get up to dirty tricks. This line of thinking goes along with words like “complex” and “opaque” – “derivatives are complex instruments …” etc.

The other way to think of the term is as a catch-all for any sort of contract whose value is determined in part by something in the world. Read more »

  • 10 Dec 2012 at 11:04 AM

Where Did Deutsche Bank Get The Losses That It Ignored Until They Went Away?

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Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.

One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1

Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.

So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:

  • You have a pool of reference assets,
  • You pay some spread to a protection writer,
  • If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
  • So for instance if there are 40% losses you get paid 25%.
  • The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.

So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:

  • The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
  • The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
  • If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3

Read more »

  • 06 Dec 2012 at 9:38 AM

Deutsche Bank Ignored Some “Losses” Until They Went Away

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Oh man, what is going on in this FT article? Here is the bottom line:

In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses.

“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants.

The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!

Here’s a synopsis of what seems to have been going on:

  • Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
  • The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
  • A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
  • Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades:

Read more »

  • 13 Nov 2012 at 12:50 PM

Goldman Is Looking Forward To Making Less Money On Standardized Derivatives So It Can Make Much More Money On Non-Standardized Derivatives

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How can you not love listening to Lloyd Blankfein? He spoke at this Merrill conference this morning and here are the slides, whatever; he is not a PowerPoint presenter, he is a philosopher. Let’s talk Philosophy of Lloyd.1

Lloyd and I share a number of passions, I assert without evidence, but a quirky one is that we both enjoy idly speculating about conservation laws in finance. In the Q&A Lloyd was asked about the clearing of derivatives and their movement to central counterparties, in which instead of banks trading opaque over-the-counter products with each other and their clients directly, taking client and fellow-bank counterparty risks, derivatives will increasingly trade in standardized cleared form with public pricing and central clearinghouse credit risk. Lloyd began by hypothesizing a “physical law of conservation of risk,” noting that “the things you do to reduce the risk of a 20-year-storm” – like reducing credit exposure to a bunch of different shaky counterparties in derivatives markets – “might make worse the risk of a 50-year storm,” like the credit exposure to one central counterparty whose failure could bring everyone down. I’m with you Lloyd: endorsed; narrow the distribution and fatten the tails etc.

The other concern about the move to clearing is that lots of people expect standardization and clearing will reduce the spreads that banks can charge on cleared things (mostly interest-rate swaps, some miscellany). Coincidentally a while back I speculated about a sort of law of conservation of abstraction, in which the abstract fantasies of our global financial system are built on the mucky underpinnings of a basement at DTCC full of damp stock certificates. That was … that was dumb, I don’t know what I was thinking.2 It’s obviously false. It’s the other way around actually: the more the inputs of the financial services industry abstract away from human activity, the more the outputs can move even higher up the abstraction chain. You see this with DTCC itself, which was seeking efficiency by dematerializing stock certificates even before a hurricane did that job for it, or in that Journal article last week about how Belgium is dematerializing its stock certificates and everyone’s all sad about it but the march of progress waits for no paper-hoarding Belgian.

You can see it especially Lloyd’s take on whether increased clearing of interest-rate swaps, etc., will help or hurt Goldman Sachs’s business. Read more »