The Assault On Liquidation Rights

oktober 24, 2014 in Columns-Artikelen by onze redactie

There is an assault brewing on the liquidation rights for swaps contracts. Banks were recently asked to give up some of their rights under the law when 18 of the largest U.S., European, and Japanese banks met in Washington DC after several months of discussions. Regulators want to delay termination rights of swaps contracts for 48 hours for troubled financial institutions. The banks agreed, and the new protocol will take effect on January 1, 2015.

The goal is a noble one. It’s an attempt to limit “fire-sales” during the worse part of a financial crisis. There’s a good case to be made for waiting 48 hours to have a counterparty that’s recapitalized and backed by the government. Just waiting these two days can prevent the entire liquidation process. On the other hand, those 18 banks are giving up liquidation rights that exist under current law. When an important foundation of a market is altered, even in a minor way, there will be consequences. Not surprising, asset managers and hedge funds are resisting the change. Since those entities are not under the same regulatory umbrella as the banks, regulators will have to compel them to comply with the new rules.

But here’s the part I’m concerned about: included in the 48 hour delay is a hold on margin collateral. That means they’re getting into the realm of the Repo market. If swaps are pushed along this route, Repo could be next.

Defaults

When a company declares bankruptcy, its assets are frozen and the company is either liquidated or reorganized. Either way, no one can touch the assets, except those which are legally exempt like Repo and swaps. Officially, they’re both exempt from the “automatic stay” provision of the bankruptcy code. Repo and swaps counterparties have the right to immediately liquidate all of their outstanding trades with the defaulted entity.

The idea behind the 48 hour delay is to prevent these liquidations and the market distorting fire-sales that result. When counterparties liquidate contracts, it makes a market crisis all the more chaotic. In a way, over the past 30 years, liquidations may have increased market volatility. Lehman Brothers is a good example. They had billions of dollars of swaps trades outstanding and within five weeks of their bankruptcy, 80% of their swaps contracts had been liquidated. It was good to get Lehman as a counterparty off of your books, but the Lehman trustee spent years in the legal system with many of these counterparties trying to claw-back collateral. Avoiding a repeat of the Lehman legal mess is one goal behind the 48 hour delay.

Dodd-Frank

Regulators were give new powers under Dodd-Frank in 2010 to seize a failing bank and keep its units operating. But in order to make it work, you can’t have their counterparties trying to liquidating their positions at the same time. Thus the 48 hour delay in termination rights. Basically, regulators need time to transfer the defaulted entity into a “bridge” holding company. As long as the new entity is well-capitalized and government backed, the swaps counterparties are giving up a bad counterparty for good a good counterparty. And there’s no need to liquidate the swaps contracts. Sounds like a win-win? But again, how much market efficiency and liquidity in normal times is being given up to limit financial market stress during bad times?

Repo Property Rights Established

Repo liquidation rights were originally established after Drysdale, then passed along to municipalities after Orange County. Swaps currently enjoy those same liquidation rights. It’s a system that made Repo and swaps markets highly liquid and highly efficient.

Back in 1982 after Drysdale defaulted, there were no bankruptcy laws on the books nor any court cases to establish the legal status of Repo in a default. No one was sure exactly how the outstanding Repo trades would be treated in a bankruptcy. If Repo was legally a “collateralized loan,” then securities held by a creditor would be stuck in the bankrupt entity. If a Repo was a sale and a repurchase transaction, then the securities could be immediately liquidated. It was a major issue that would have ramifications going forward.

Though Chase Manhattan Bank covered Drysdale’s loss and took over Drysdale to liquidate them, there was no immediate resolution of the Repo liquidation rights issue. The issue came up again just three months later when another firm, Lombard-Wall, collapsed in August 1982. In September 1982, one month later, the Federal Bankruptcy Court of New York ruled that a Repo was a sale and repurchase transaction, making it two separate transactions and thus not a single collateralized loan. The court recognized that allowing prompt liquidation was necessary to continue the orderly functioning of the markets. Two years later, in 1984, Congress passed an extension of the Federal Bankruptcy laws so that Repo on Treasurys, Federal Agencys, CDs and BAs were exempt from automatic stays in a bankruptcy by law. The Repo market was off and running, but one aspect of the bankruptcy code was overlooked – municipalities.

Repo Property Rights In Orange County

On December 6, 1994 Credit Suisse First Boston demanded repayment of $2 billion of the Repo trades that they had executed with Robert Citron, the Treasurer of Orange County, California and they immediately seized $1.25 billion of Orange County’s securities. Later that day, Orange County declared bankruptcy, making it the largest municipal bankruptcy in the history of the United States up until that time.

When the county declared Chapter 9 bankruptcy to seek protection, they thought they were preventing a run on their investment portfolio and they’d prevent their Repo counterparties from liquidating their securities. Chapter 9 bankruptcy is a specific type of reorganization reserved solely for municipalities. When the Bankruptcy Act came into being in 1934, a part of it was called Chapter 9 and it allowed specifically for bankruptcy protection to municipalities. A very important feature of Chapter 9 is that the law specifically did not include Section 559 of the larger bankruptcy code. Section 559 allows a repo counterparty to liquidate repurchase agreements in order to recoup their money. In other words, whereas the whole Repo market was set up so that a creditor can sell the collateral in the event of default, Chapter 9 bankruptcy prohibited – or at least didn’t explicitly allow – it to happen. It was, at the time, an untested loophole in the law. Orange County officials were pinning their hopes that by declaring Chapter 9, their Repo counterparties would have their hands tied and wouldn’t be able to liquidate the securities.

Ironically – and perhaps predictably – when Orange County filed for bankruptcy, the result was the exact opposite. The Wall Street firms interpreted the bankruptcy filing as a default, which it was, and began to enforce the terms of the Repo agreements. That meant they all began liquidating Orange County’s positions.

Merrill was the next one to launch a liquidation salvo, selling off all of $800 million in securities that they were holding . The firm contented that they were legally allowed to sell off the securities, because the Repo legal agreement allowed for liquidation in the event of a default. The Orange County Board of Supervisors begged to differ and they authorized their lawyers to begin filing lawsuits against any Wall Street firm that liquidated securities. They alleged that selling collateral was illegal under the Chapter 9 because there was no mention of Repo agreements in the law. Banks were, therefore, legally obligated to return the securities to Orange County. Their argument, though legally clever, fell on deaf ears and the other liquidations proceeded.

Repo Consequences

All of the same arguments used to suspend swaps liquidation rights could be used to suspend Repo liquidation rights. In the near future, we could see regulators asking Repo counterparties to wait 48 hours before liquidating securities financing transactions. The problem is: Repo is fundamentally different from swaps. In swaps, the two parties agreed to pay the differential (say fixed versus floating) on the notional amount of the trade. It’s all about cash flow. In Repo, the two counterparties actually exchange the notional amount; that is, they exchange cash and securities. If the Repo market were asked to suspend its liquidation rights for 48 hours, the counterparties would be giving up their rights for their cash or their securities for that period of time. It’s a larger issue than waiting for a differential on cash flow for 48 hours.

If the 48 hour waiting period is extended to the Repo market, I’m worried about the unintended consequences. What helps during a market crisis, might hurt the market the other 99.9% of the time. If a bank is teetering on the brink of collapse and their Repo counterparties know their liquidation rights will be suspended for two days, they may pull their funding faster. During that 48 hour waiting period, there will be market distortions. Uncertainty will drive counterparties to panic and act in unexpected ways.

Overall, suspending the liquidation rights for swaps for 48 hours will help address the fire-sale issue, but I’m worried the tradeoff will have unintended consequences. Does market stability during a one week period justify market distortions for the 10 to 20 years in between? That’s a crucial question. I’m not sure the correct answer, but I am certain there are tradeoffs.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

5 Proposals For “Fire-Sale” Risk And Repo Reform

oktober 8, 2013 in Columns-Artikelen by onze redactie

I attended the Federal Reserve’s conference on “Fire Sales as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets” on Friday, October 4, 2013. I want to share the proposals out there about the fire-sale issue. There were three formal proposals presented, one additional suggestion by a panel speaker, and then I added my own personal proposal at the end of this article.

First off, let’s be clear, the Fed specifically does not advocate any solution that was presented. Additional, I won’t go into the basics of Tri-Party Repo reform and “fire-sales,” I did that a few months ago in Tri-Party Reform Then And Now. However, I will start with the Fed’s definition of a fire-sale. It’s when an entity is forced to sell quickly and at a low price. The key part here is that others must be harmed by the “fire-sale;” other market participants who were not part of the original Repo transaction. As one official noted, “We don’t care if people run, as long as it’s not systemic.”

1. New Regulation

Remember the Bill Dudley (President of the New York Fed) speech last February? He said pretty clearly that if market participants don’t reform the Repo market and address fire-sale risk, the Fed will do it through new regulation. They certainly haven’t been sitting on their thumbs the past eight months. First, let’s note is that current regulation (Dodd-Frank, Basel III) was not designed to address fire-sales. It just wasn’t on the radar of top government officials at the time. Even if it was, leverage ratios and increased capital requirements would only address fire-sales and Repo reform indirectly. Instead of targeting banks overall, it’s better to look one level down and target the matched-book businesses themselves. Go straight to the source – reform the Repo businesses within the banks instead of the banks overall.

Therefore, new regulation could mean a leverage ratio specific for Repo matched-books, or perhaps a capital charge for the larger bank matched-books. I was surprised to hear that they already have a name for it, “Net Stable Funding Ratio.” Perhaps it’s further along than we expected. It doesn’t end here, there’s still another possibility.

Suppose you drill down one level further and target the securities themselves with “universal margin requirements.” As it turns out, this is the solution that academics like the most. Deal with the problem on the securities level. That means financing haircuts would be larger than they are now. In a way, it’s still like a leverage ratio and/or capital charge. Larger haircuts mean the securities owners must put up more capital to be in the business. Less leverage and more capital makes the system more stable, but it still doesn’t necessarily solve the fire-sale issue. If someone goes down, even with more Repo regulation, the liquidation issue is still out there.

2. Repo Resolution Authority

Another speaker proposed a market sponsored liquidation facility. I’ve heard this type of idea floated around before. It’s based on an industry sponsored facility that takes over a failing entity’s positions and liquidates them. At first glance, it sounds pretty good. In one way, it’s a throwback to the clearinghouses of yesteryear (See my History of Central Clearing Counterparties), so there’s a historical background and a good precedent. It was a good system before the Federal Reserve was established in 1913, but the clearinghouse liquidation function became obsolete once the banking system had a “lender of the last resort” in the Fed.

Many proponents of this idea use Long Term Capital Management as a showcase. When LTCM was failing, their counterparties (who were holding many of the same trades as LTCM) pooled their funds together, took over LTCM, and unwound their positions over time at a pace which did not stress the market. In the LTCM case, it was successful.

However, in order to institutionalize such an authority, there are a couple of major problems. The Repo market’s exemption from the automatic stay provision of the bankruptcy code (see my market commentary on Two Bankruptcies That Created The Modern Repo Market) would have to be changed. That’s a big problem. One of the main pillars of the Repo market is that the non-defaulting entity has immediate liquidation rights. Imaging waiting weeks or months to get your cash or securities back? The Repo market would mostly go away. From a practical standpoint, any solution that requires changes in the bankruptcy status of Repo is a non-starter.

Then, one questioner asked, “Where does the capital come from?” The answer was that all market participants would be required to contribute. A couple hundred million dollars is one thing, but what if Bear Stearns went bust with $30 billion in illiquid securities. Where would the authority get that kind of money? Obviously, they need funding from the Fed.

3. Remove The Tri-Party Function From The Clearing Bank

The third approach was to target the infrastructure of the Tri-Party system, the “plumbing. There are two main Tri-Party clearing banks. There used to be more clearing banks, but they disappeared through consolidation and mergers. Right now, in fact, one bank accounts for about 80% of clearing activity. The premise is that clearing has a competitive advantage with larger scale and the market is moving toward a monopoly structure anyway. Remember AT&T? As the nationwide phone system was being created, the efficiencies offered by a monopoly served as a more competitive structure. A national telephone utility was a more efficient business model, at least until it wasn’t and then it was broken up.

The idea here is to remove the Tri-Party function from the clearing bank and create a utility within a special purpose entity. It would have state-of-the-art technology and access to back-up liquidity from the Fed.

One immediate benefit removes the conflicts of interest from “complex” clearing banks. Remember JP Morgan and Lehman, then there was JP Morgan and MF Global. Obviously you see the pattern.

Now, I’m a free market thinker, so I believe that having more clearing banks and fostering more competition is a better solution, in principle. A more open system with more competition is always going to be better than a government run monopoly. I also wondered that when such a clearing utility was yanked out of the main clearing bank, would the broken up entities be nicknamed “the baby-BONYs”?

4. Investment Advisors

There was another proposal informally put forth by a panel member. He suggested that the liquidation function be given to an elite group of large investment banks. Since they have the risk management skills and experience with liquidations, they’re the best equipped to handle the situation. That the market is better off in a liquidation with a third party involved. In fact, this system is already used by central clearing counterparties. Oh, and as it happens, this person’s investment bank happens to run a large business in the space.

5. The “Open Access Liquidity Program” – My Solution

Where the other solutions took about 45 minutes present and explain, my solution is pretty easy and can be done in about 10 minutes. I’ll start off with a hint: both the Repo Resolution Authority and clearing utility have one thing in common, they’re camouflage for access to the Fed’s “lender of last resort.”

In order to devise a solution, it’s best to go back and look at the real problem. Back in 2007, investment funds were over-leveraged and lost liquidity, including Bear Stearns Asset Management, BNP Paribas funds, Sentinel Capital Management, and the Carlyle funds. Then, in 2008, banks and investment banks were over-leveraged and lost liquidity. The original intent of TARP was to buy distressed assets. That’s where the system was clogged. There were too many bad assets and no one to buy them. Right after TARP was passed, it was realized that buying distressed assets was too complicated and would  take too long. Instead, TARP funds were used to buy preferred equity stakes in the distressed banks.

Going back to the original intent of TARP was government provided liquidity, that is, back-up funding. Basically, a “lender of last resort.” Wait, that’s something the Fed is supposed to do anyway. It’s one of the founding principles of central banking. Well, the banking system has changed a lot in the past 100 years. Banking functions are performed by non-banks, the “shadow banks.” So here’s the problem: there is back-up liquidity support for traditional banking, but not for shadow banking. Central bank liquidity did not evolve with the changes in the banking system, it remained static.

That’s the problem today: money funds, broker-dealers, FCMs, asset-backed conduits, hedge funds, etc. don’t have access to back-up funding from the Fed.

Here’s the solution. The Fed has a large QE portfolio of Treasurys, Agencys and Agency MBS. The market needs a Fed liquidity program to convert illiquid securities into liquid securities at times of stress. The Fed would expand its list of counterparties even further; much more than the 139 used for Reverse-Repo operations. The new Fed liquidity program would be like the securities lending program, but instead take illiquid securities in exchange for liquid ones. There would be different classes of securities with different haircuts and spreads. For example, the Fed might swap AA-rated CMBS for Treasurys at a fixed spread of 200 bps with a 35% haircut. The basis point spread and haircut must be punitive, given the facility is not supposed to be a day-to-day source of funding for anyone. It’s only for times of crisis.

The “Open Access Liquidity Program” would give all financial institutions access to liquidity. The Fed becomes the “lender of last resort” for the whole banking system. Let’s just say the Fed’s role is updated to meet the needs of the modern banking system. During a time of crisis, this funding program will give an institution time to wind down because they have access to funding. It means fire-sales are less likely when the institution can be unwound over a longer period of time. The program preserves value in the economy because the other businesses within the institution are not wrecked, they continue to function. Picture all the good businesses that were wrecked from the illiquid real-estate holdings of Lehman Brothers. Suppose the “Open Access Liquidity Program” was alive in March of 2008. Back then, Bear Stearns could not fund their CMBS, RMBS, or other private-label securities. They were solvent but not liquid. With the program I propose, Bear could have continued had they been able to swap their distressed securities at the Fed for Treasurys.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Liquidations And Fire-Sales

mei 23, 2013 in Columns-Artikelen by onze redactie

The first recorded instance of the term “fire sale” is thought to come from an advertisement posted by Maraton Upton, a resident of Fitchburg, Massachusetts, who had suffered through a massive fire at his home in December 1856. Following the destruction, Upton no doubt needed money for recovery, so he took out an advertisement that read in part, “Extraordinary fire sale; customers are invited to call and examine goods which are still warm.”

These days fire-sale is a term used in many facets of American life. Regardless of the setting, however, the meaning is almost always the same: something is for sale, condition notwithstanding, for significantly less than it would cost new. For that matter, not only is it less than a discounted price, the term implies the items are being sold at a drastically reduced price.

Financial Market Fire-Sales

In the financial world, fire-sales often occur after an entity defaults and its counterparties are forced to sell-off its positions. The Fed is currently worried about the impact of fire-sales on the financial markets in what they call a “collective action problem” -  if everyone sells at once, it drives prices down even further than if everyone coordinated their sales. It’s kind of like the “prisoner’s dilemma” for financial markets, where the first one to talk (sell) can get themselves a better deal. But if the prisoner’s (dealers) all cooperated, they’d get themselves a better deal together as a whole. The Fed is pushing the idea of an industry consortium to liquidate defaulted counterparties in the Repo market, specifically in the Tri-Party Repo market.

Long Term Capital Management – The Success of A Dealer Consortium

In one respect, the fate of LTCM can be viewed as a successful dealer consortium that resolved a default.  In the case of LTCM, all* of their counterparties contributed funds for an orderly wind down. When LTCM collapsed in 1998, not only did the Street have massive amounts of exposure to them through Repo financing trades, but there was also correlation risk with the big dealers’ proprietary trading positions – they all had many of the same trades on.  It was certainly in the Street’s best interest for LTCM to be wound down in an orderly manner, otherwise they’d all be liquidating LTCM at once.  When the Fed hosted the bailout meeting, the interested parties agreed to contribute $3.625 billion to fund the rescue. After the liquidation was complete, the industry even made money on the bailout. There’s a good argument to be made for an industry consortium taking over the failing entity and winding down their positions in an orderly manner.

Amaranth – The Uncertainty of Bankruptcy Court

In 2005, a little known natural gas trader named Brian Hunter at a hedge fund named Amaranth Advisors made a big bet that natural gas prices would increase for the Winter 2005-06 natural gas season.  After hurricane Katrina hit followed by hurricane Rita, it knocked out natural gas facilities and pipelines in the Gulf of Mexico. Hunter and Amaranth made a killing, they were up over $1 billion on the trade.  Figuring the same thing would happen the next year, Hunter placed an even bigger bet on natural gas futures and OTC swaps in early 2006, controlling as much as 60%-70% of the winter delivery season. The 2006 hurricane season was a dud and Hunter’s positions were so large, Amaranth could not get out.  They managed to hold on until the middle of September as natural gas prices were in a free fall, but they eventually succumbed to margin calls. Around September 15, Amaranth was down to net assets of $3.5 billion, after having lost over $5 billion so far that year. They struck a deal with Goldman Sachs to buy their entire energy portfolio, but there was one catch, JP Morgan, Amaranth’s futures clearer, had loaned Amaranth money against their futures positions.** JP Morgan had a claim to the assets, which meant funds could potentially be “clawed back” in bankruptcy court years later.  Faced with the uncertainty of an unfavorable ruling in court, Goldman backed out of the deal. Soon after, Amaranth’s positions were sold to a group consisting of JP Morgan and Citadel for the sum of $2.5 billion.

The bottom line is that no one wants to be tired up in bankruptcy court and no one wants an unknown potential liability down the road. When there are large degrees of uncertainty, market participants pull out of a market or increase their bid/offer spreads to reflect the potential of additional costs.

BSAM – The Problem of Holding Positions Too Long

The CDO market in 2007 is the perfect example of contagion that can be caused by fire-sales and the downward spiral of prices. Leading up to 2007, the CDO market had already peaked and began to decline sometime in 2006.  Some dealers were more aggressive than others in market down their customer’s CDO positions, but eventually the entire market was eventually forced into decline. As margin calls increased and forced sales pushed prices lower, one leveraged fund after another collapsed, forcing more sales and pushing CDO prices even lower, which then forced more leveraged players into default.

One of the domino’s that fell in June 2007 was Bear Stearns Asset Management (BSAM). Merrill Lynch was one of their Repo counterparties who were forced to take over the billions of BSAM’s CDOs that Merrill Lynch was financing. Merrill made a catastrophic mistake in the liquidation – when they couldn’t sell the positions at prices they deemed acceptable, they held onto the paper. Down the road, they were force to take even larger losses and some their CDO paper was held until it was worthless.

If there was an industry consortium in charge of an orderly BSAM wind down, there’s a good chance they would have done what Merrill did and held onto the positions, especially if traders at Merrill were recommending that strategy. Getting back to the downward spiral of prices, had some industry consortium liquidated failing entities, does anyone honestly think those leverage funds would still be alive today had they not collapsed in 2007? In this case an industry liquidation consortium would have just slowed down the decline of the market and spread losses around the entire industry, away from institutions, like Merrill, which had made bad business decisions.

Lehman – The Success of Central Clearing Party (CCP) Liquidations

Though Lehman is blamed for causing financial havoc across the globe, unwinding Lehman’s Repo book was not a large problem. Lehman was a member of LCH.Clearnet in Europe and Fixed Income Clearing Corp (FICC) in the U.S. After Lehman declared bankruptcy, both CCPs liquidating Lehman’s Repo positions and neither CCP reported a loss or called on their default fund. Repo liquidations worked very well under the extreme market conditions of September and October of 2008. However, other parts of the Lehman liquidation did not go so well, in fact, Lehman is still being wound down almost 6 years later.

MF Global – The Problem With A CCP Liquidation

Before MF Global declared bankruptcy, the “cat was out of the bag,” so to speak, and market participants knew MF Global would be liquidating their Sovereign bond portfolio among their other positions. After the bankruptcy was declared, LCH.Clearnet assumed control of the portfolio and arranged an auction. For one of the buyers, George Soros, the purchase was extremely lucrative. In total he purchased approximately $2 billion worth of the $4.8 billion RTM (repo-to-maturity) securities that were offered for sale. For the Italian bonds, he paid approximately 89 cents on the dollar, compared to the market price of 94 cents and within a month those bonds were back up to a price of 96, making Soros a $140 million profit in the space of a very short period of time.

There is, of course, no way of knowing the full extent of all the losses due to the “fire sale” of MF Global and certainly under better circumstances a liquidation could have been handled better. Looking at the numbers, we can surmise the approximate damage done to MF Global’s bottom line. For starters, the firm took a $7.3 million loss on the sale of $600 million worth of RTM positions before the bankruptcy. The sale of commercial paper to Goldman Sachs for $1.33 billion had resulted in a loss of $15 million. Soros had paid $2 billion for a portion of the RTM portfolio, costing MF Global another $120 million, with the remainder of the RTM positions selling at a 10% discount, which adds another $280 million to the loss ledger. Moving on, we come to the $418 million worth of corporate securities the firm held, which were sold for $384 million, a loss of about $34 million. An additional $600 million worth of relatively illiquid securities were on the books, which we can conservatively guess were sold at a 10% discount, meaning they lost the firm another $60 million.

Assuming a negligible loss or even a slight profit realized on the sale of the remaining assets in the firm’s holdings – which included several billion dollars in federal agencys and U.S. Treasurys – the total cost of unwinding MF Global’s trading positions in a one week fire-sale topped out at over $500 million.

Problems with a Dealer Consortium

The dealer consortium worked well during the LTCM crisis, but it wouldn’t have necessarily work well under other markets. If you know the market will remain stable and eventually return to normal conditions, the dealer liquidation consortium is a good way to go.  However, if the market will continue to decline, a consortium is a bad idea.

You can say the right to a quick liquidation is what makes the Repo market possible in the first place. It’s pretty clear that if LTCM’s Repo agreements had specified that: “In the case of LTCM’s failure, you will join a consortium of banks and invest $300 million of your own capital while the fund is wound down,” then LTCM never would have been in business in the first place. The right to liquidate Repo transactions quickly and easily in the event of a default makes Repo financing possible and is responsible for the size and efficiency of the Repo market today.

Another problem with the dealer consortium is the potential conflicts of interest it creates. If the chickens are disappearing from the hen-house, it probably doesn’t make sense to let the foxes take turns guarding them at night. Just before LTCM went down and the fund was frantically looking for a buyer, Jon Corzine’s traders at Goldman were seen downloading LTCM’s positions onto a laptop computer. Many firms involved in a liquidation could also benefit from the liquidation.

There’s another risk too: an orderly unwind requires someone to make market trading decisions. Is it better to hold the securities for months or sell them now? Collective industry solutions involve taking market risk and a view on whether the market will “recover.” That worked in 1998 for LTCM, but it would not have worked in 2007, just ask Merrill. As the months went on, Merrill watched the CDO market continue to deteriorate and eventually took billions of dollars in losses.

Then there is the issue of the bankruptcy court. Any “trading” decisions that are made to hold securities means there’s potentially a liability in bankruptcy court.  If market prices deteriorate and someone made the decision to ride the losses, then the Trustee is coming after those losses. Liquidation trading decisions open the door to potentially millions or billions of unknown liabilities down the road.

Hosting A Fire-Sale

I had the opportunity (not sure if that’s the right word) to liquidate a large Repo customer once. It was a well known name, and of course, it was right in the middle of a financial crisis. Obviously, there’s no coincidence these things happen at the worst times. This customer was leveraged with well over a billion dollars in corporate bonds, structured corporate bonds, and some CDOs, plus small amounts of U.S. Treasurys and federal agencies.

One of the hardest parts of a fire-sale liquidation is that you’re unsure of the outcome. As soon as you legally take over the customer’s positions, you’re in a no win and possible lose position.  If you sell the positions and there’s excess cash left over, you must return the funds to the estate.  If you’re sitting on a a loss after the liquidation, you then stand in line at the bankruptcy, not expecting a settlement for years. When the bankruptcy does get resolved, you’ll probably receive a fraction of what you’re owed.

So the key to the liquidation rests on not losing money when the customer positions are sold, and that rests on the mark-to-market prices and the margin you’re holding. If the prices and margin are sufficient, there’s a good chance of getting out of the liquidation unscathed. If the mark-to-market prices are inaccurate and the margin doesn’t cover the movement in market prices, you’ll be staring at a loss. What’s worse, you don’t know the size of that loss until the liquidation is complete.

Here are my recommendations for handling a liquidation:

  1. Devise A Plan – Determine how much to sell each day, the maximum loss you’ll accept on a security, who you’re going to speak with, and who you trust.
  2. Counterparties – Determine who is the best to bid for the different types of paper.  For example, some banks are better for CDO prices and the individual banks should be the best bid on their own paper.
  3. Keep A Low Profile – The key is to not to let the Street know the customer’s positions and their size. If the Street gets access to too much information, they’ll front-run you.
  4. Stick To The Plan – When there’s a loss or prices are lower than you expect, sell them and don’t try to trade out of a bad market.  Holding can work sometimes, but as a rule of thumb, it’s worst strategy. As we’ve seen, holding positions will also open up the liquidator to questions from the Trustee years later.

* Except one, Bear Stearns, but that issue is debatable considering Bear was LTCM’s clearing firm and had potentially more  liability than the other firms.

** Called “margin finance” in the futures industry.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.