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Markets Regulation
Swaps reform aims to prevent next Lehman
From the Financial Times of Wed, 08 Oct 2014 18:24:50 GMT
The exterior of the world headquarters for Lehman Brothers can be seen in New York, May 19, 2008. Citigroup slashed its earnings outlook for Wall Street investment banks, Goldman Sachs Group Inc, Lehman Brothers Holdings Inc and Morgan Stanley on Monday, citing a tough operating environment. REUTERS/Lucas Jackson (UNITED STATES)©Reuters

When Lehman Brothers collapsed in September 2008, it sent shockwaves through the financial system – and an army of junior lawyers flooding into the City of London and Wall Street.

Lehman was on the other side of billions of dollars worth of derivatives trades that had been struck with other banks, large investors and financial firms.

Many of these so-called “counterparties” were holding valuable amounts of collateral, or security, that Lehman had posted to them to help back up its trades as its creditworthiness plunged.

Under the terms of such swap agreements, counterparties had the option to close out their trades with the defaulted Lehman and keep the collateral the bank had already given them. About 80 per cent of Lehman’s derivatives counterparties did just that within five weeks of its Chapter 11 bankruptcy filing, with lawyers faxing, phoning and sometimes hand-delivering notices to Lehman representatives to inform them that a counterparty was terminating its trades.

That quick action helped many firms mitigate their exposure to the failed bank during a time of financial panic, but it also meant that Lehman’s estate had to spend years in court trying to claw back collateral. What was left of Lehman was also worth far less than if the derivatives contracts had been intact.

Since then, much of the derivatives world has been overhauled, but crucial tweaks governing how counterparties react to a failed bank have lagged behind. That is finally changing.

The biggest banks have agreed to rewrite rules governing the bulk of derivatives trades so that counterparties give up their right to pull the plug on contracts made with a crisis-stricken institution.

The move is intended to bring derivatives in line with the sweeping US financial reform contained in the Dodd-Frank Act of 2010. It includes a provision that briefly suspends the right of counterparties to terminate trades with a collapsed bank.

Global OTC derivatives

Politicians enacted such a “stay,” or freezing of assets, in order to give regulators a grace period to potentially transfer the collapsed bank to a new resolution regime that is aimed at unwinding failed banks in a more orderly fashion.

Banks have now agreed to embed a similar stay in the document that governs most derivatives contracts, known as the International Swaps and Derivatives Association, or “Isda Master Agreement,” according to people familiar with the matter.

Despite the agreement, there remains work to do. The US bankruptcy code still exempts derivatives from rules that stop companies from withdrawing money from stricken firms shortly before a bankruptcy.

The American Bankruptcy Institute has been studying the possibility of eliminating this “safe harbour provision” for the past few years, but there appears to be little political momentum in Washington to tackle the issue.

The current approach has also been criticised by prominent US politicians as circumventing the domestic rule of law.

“I am nevertheless concerned about the threat to the rule of law posed by the approach you appear to have undertaken to address this issue in an unaccountable international forum,” said Jeb Hensarling, House financial services committee chairman in a letter to the Federal Reserve last month.

Other critics have said the industry-led derivatives rewrite is a piecemeal solution to a lingering problem – and one that could end up exacerbating a future run on banks.

“If I’m a derivatives counterparty and I think a firm is about to fail, I’m going to try to figure out a way to get my money out before the firm is insolvent,” said Craig Pirrong, professor of finance at the University of Houston.

“Having a stay but allowing derivatives counterparties to get money out of a firm before it goes into bankruptcy creates perverse incentives.”

Additional reporting by Gina Chon in Washington

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