Papagianis, Zingales on CDS Resolution Reform

Christopher Papagianis at Economics 21 has some has some advice for Republicans on ways to make the Dodd financial reform bill better; use some insights from Oliver Hart and Luigi Zingales. It’s worth reading all of it, but I’ll try and summarize. First, he describes resolution authority in a smart way:

The Democrats’ “resolution authority” proposal needs to be thought of in two discrete time periods: the “crisis” period, when the firm is on the verge of collapse, and the “ordinary” period when the firm is able to access external funding and otherwise function normally. During the “crisis” period, resolution authority is quite useful as it provides the government with greater legal authority to assume control of a firm on the brink of failure. As the Treasury has argued, current law forces the Administration and Federal Reserve to choose between two unpalatable options: (1) government capital injections and financial guarantees (as occurred with AIG), or (2) a bankruptcy filing (as occurred with Lehman Brothers). In the first case, the government uses taxpayer resources to keep an insolvent firm afloat without the ability to alter contracts or otherwise wind-down the institution. In the second, the government takes a hands-off approach and allows an uncontrolled bankruptcy to occur with no ability to monitor or control the potentially significant collateral damage.

The problem is that this crisis period is very short in duration relative to the “ordinary” period when the firm is not on the verge of collapse. During the ordinary period, the resolution authority and the accompanying “resolution fund” are likely to distort prices and capital allocation decisions. The result is subsidies for larger institutions that could make it harder for small banks to attract debt finance and a less stable financial system.

The question at hand is how to deal with the detection part, the part where you go from ordinary to crisis, a question I worry about as well. What is to be done?

Instead of acceding to this plan, Republicans should get behind a variant of a proposal offered by distinguished academics Oliver Hart and Luigi Zingales. Hart and Zingales would use credit default swap (CDS) spreads as a market-based default probability metric. The “spread” or premium on a CDS contract represents the market price of providing a financial guarantee against losses from a firm’s default. A rising CDS spread is a market signal that the probability of default is increasing because it is getting more expensive to purchase protection against default. In the Hart and Zingales framework, once the CDS spread rises above a pre-specified “critical threshold,” the regulator would force the institution in question to issue equity (offer new stock for sale) until the CDS spread moves back below the threshold…

While Hart and Zingales choose the right instrument for their trigger, their proposed remedial step should be strengthened. Instead of having the regulator demand that the institution issue new equity, the debt of the institution could automatically convert into equity….If that failed to bring the CDS below the critical threshold, the other half of the junior debt would also convert to equity….The GOP should seize the opportunity.

If that doesn’t make sense to you, essentially it means that credit default swaps on bank debt, or market expectations of credit risk, should be used as the trigger for when a systemically risky financial firm should be resolved (or moved further along in the process of resolution). Ok, several things:

1) This may not be obvious to people who weren’t watching the House debate on financial reform, but one of the Republicans signature contributions to the debate is to say absolutely no changes need to be made to the credit default swap and over-the-counter derivatives market. None. Check out the House GOP Alternative plan (summary, derivatives). Nothing.

And the Republicans are lining up to go to war against any attempt to bring any type of regulation to the credit default swap market. We aren’t even talking about serious Gensler style derivatives reform. The Republicans are fighting against clearing requirements. Against post-trade price transparency reform, and pre-trade price transparency reform. No pressure on the derivatives dealers. Nothing. 88% of Republicans on the House Financial Services committee voted against bringing Title III, the derivatives act, out of the House. And that’s the reform Frank retroactively thinks was weak!

So the question for Chris right out the door is whether or not he can recommend pushing for credit default swaps to play an important role in our regulatory regime with the current OTC market, and if not what OTC changes would need to be made. I think the idea has a lot of potential, but with the derivatives market the way it currently is it could be a disaster, subject to an excessive amount of noise, distortion and manipulation.

2) Moving on, let’s put the policy under a microscope. It’s a resolution bill, not a bankruptcy bill. It doesn’t wait until a firm can’t make a payment on its debt to be closed, it has a predetermined event that has the firm taken into receivership like FDIC does with a bank. This is an important difference with the current GOP approach, which would be like waiting until someone can’t get money out of their checking account to take over a failed bank. Getting in early allows for a smoother transition to a receivership like event. This is a new discussion on the Right, which has been focused on doubling down on bankruptcy law during the past year.

3) A big question is who gets to pull the trigger on a resolution event. Is it the regulator’s discretion? Is it hard rules only? The Dodd Bill uses a combination of both similar to prompt corrective action to try and take advantage of regulator’s knowledge (that the market will not have, especially with regards to debt tenor of a financial firm’s books, important for shadow banking stuff) while also combating regulatory forbearance. Chris would have the credit default swap market make the call as to when to begin the resolution process. I like this idea in (financial) theory, though I’m not sure if the market can see much of the stuff that is quite important for making sure a financial firm isn’t placing itself at risk for a shadow banking run.

4) One problem I would worry about is that it might be pro-cyclical, when regulation needs to be counter-cyclical going forward. So while Zingales says that the CDS market predicted the collapses in 2008 of many firms, he doesn’t mention that the CDS prices on the collapsed financial firms in 2007 were at an all-time low. (See a graph of Lehman’s CDS prices.) Regulators should have been harder on Lehman during the boom and easier on them during the crisis; this idea for resolution is certainly compatible with counter-cyclical regulation but it doesn’t get there by itself.

5) I’m skeptical that CDS prices purely reflect default probabilities. As credit risk trader Sandrew has said: “Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen…It follows that extrapolating any default information from wider CDS spreads can be misleading.” Others worry that the prices reflect what a handful of broker-dealers want you to believe. Getting a better tracker with better price discovery might get us closer to this doing what it needs to, but we are a long way away from there.

6) A big problem with automatic, clearly displayed rules on a CDS tracker would be that it could radically amplify the death spiral financing risks that these kinds of things encounter. As the CDS prices gets closer to the trigger, there’s more of an incentive for people to pile into the CDS to try and force a regulatory intervention. It would actually give quants an equation and reasonable data estimates for how much capital and energy it would take to trigger a profitable bank run; and since the CDS will actually trigger it, smart money wouldn’t want to fight against them to retain the value of the firm but also pile onto the push. In general bank runs are not profitable for most of the people involved in them. But here triggering one could in fact make it very profitable for some of the players who also have nothing to lose.

I need to think more about the #6 critique as a hard rule that must be followed, but I completely support the idea of regulators using CDS information as a major weapon in their toolbox. But there are some smart credit risk people who read this blog: what do you think?

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12 Responses to Papagianis, Zingales on CDS Resolution Reform

  1. I had a post on the Hart and Zingales idea when it came out last May (it was in mark Thoma’s links). I see some big problems with it. Here’s a key one from that post:

    The CDS may be a poor measure of the large financial institution’s probability of failure absent government assistance, because the market will price the CDS to include the substantial likelihood that the government will pump in taxpayer money if the large financial institution (LFI) would otherwise go under.

    Even if the LFI were being run in an extremely risky way (because management was taking advantage of the “heads I win, tails you lose” taxpayer backup likelihood), the CDS could still be very low priced, if the market knows the government is likely to bail the LFI out.

    Even if the LFI would almost surely go bankrupt without government assistance, the CDS might not be particularly low priced if investors think it hardly matters; the tax payers will almost surely give the LFI billions to keep it from bankruptcy.

    at: http://richardhserlin.blogspot.com/2009/05/will-cds-really-reflect-well-what-hart.html

    • Ted says:

      Correct me if I’m wrong, but the Hart / Zingales plan doesn’t allow for taxpayer money to be injected, or does it? My reading of their plan is that once a bank is declared in trouble that if they don’t raise capital, the regulator appoints a receiver / trustee. The receiver / trustee re-capitalizes and sells of the assets while wiping out the shareholders and forcing the creditors to take a haircut of some kind. My reading is that their plan doesn’t allow for a government bailout – so why would the market expect that?

      • Here is what Hart and Zingales said in their article of March 2009 (that I posted on):

        In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI [Large Financial Institution] to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.

        at: http://experts.foreignpolicy.com/posts/2009/03/30/to_regulate_finance_try_the_market

        So, as you can see, there is this “the regulator will take over” if the LFI doesn’t issue stock (and probably if a stock issue can’t raise enough money to adequately cover the outstanding debt).

        Now, once the regulator takes over, he could just let the LFI go into complete bankruptcy even if it would result in massive losses for debt holders and counterparties on derivatives. But, as we’ve seen, this could plunge the economy into a recession, or worse. So there will be great pressure on the government to bail out the LFI and its debt holders and derivative counter parties – and the CDS market will know this ex-ante, and so may not price the CDS of the LFI very high even if it knows the LFI is being run in a very risky way – because the risk is to a large extent to the tax payers, not to the LFI, or its bondholders and counter parties.

      • I should have added that what I’m saying is even a lot more true since the giant bailouts of 2008. As I wrote later in my May 2009 post:

        …their idea would be put into effect after the information in the CDS became less reliable due to the government bailouts of Bear Stearns, AIG, etc. That’s the world we’re living in now, one where investors saw in 2008-9 a demonstration of the great lengths the government would go to to keep LFI’s from failing, especially when they are so interlinked. This may strongly increase investors’ confidence that the government would do it again in the future.

        The authors claim that their CDS idea would work well only by looking at CDS prices in the world before the recent spate of hundreds of billions of dollars of bailouts.

        at: http://richardhserlin.blogspot.com/2009/05/will-cds-really-reflect-well-what-hart.html

      • I should add, because my May 2009 post did not make this clear, that I do support having some strong smart “objective” limits on shadow banks, of any size, LFI or SFI, things like leverage limits. Clearly we’ve seen that Republican regulators, or “regulators” can’t be trusted with complete discretion.’

      • Also, I’ve updated my May 2009 post to make what’s in my last comment clear. I certainly don’t want anyone to think that I believe Republican regulators can be allowed complete discretion to let business do whatever harm it wants.

  2. Ted says:

    My understanding of the Hart/Zingales proposal is that regulatory discretion is only partially removed. I believe their proposal is that once the CDS passes 100 bps for 20 of the last 30 days (or something like that), the regulatory invokes a stress test. At the same time, while the stress test is occurring, the banks assets become backed by the full faith and credit of the U.S. government. Shouldn’t that mitigate the possibility of a shadow-bank run since there is essentially a guarantee in the mean time? Then, once the stress test is done the regulator either declares the bank needs to raise capital or it says the bank is fine. In order to give the market confidence that the bank is fine, their proposal says that the regulator would then inject liquidity (though they don’t specify any kind of formula to calculate how much). Shouldn’t that mitigate the ability of a few quants to execute a bank run on a profitable firm, since essentially by activating the trigger they would be activating an equivalent of a deposit guarantee?

    Of course, didn’t the New York Fed just throw out the Lehman stress test? I think we’d need a way to assure the stress test wasn’t just phony, or wasn’t fudged in some way due to regulatory capture. Also, I like Hart / Zingales need to emphasize more that, I think, for their plan to even remotely work we need a clearinghouse requirement for this stuff. I want more transparency before we’d even consider using this as a regulatory trigger.

    Finally, I don’t think the Hart / Zingales plan is bad per-say. What I worry is that there may be a way to game this system somehow without more strict requirements. There are things we don’t understand fully, especially because the market keeps evolving, so to put so much faith in the CDS market seems too idealistic. I think the CDS trigger should play some type of role (maybe even a large role), but I’m not sure it should play the only role.

  3. Sandrew says:

    Correction: The quote you attributed to me isn’t mine, but A Credit Trader’s. In fact, I believe I quibbled with him over it at the time. Also, I’m not a credit trader.

    In any event, I agree in principle with the sentiment that CDS spreads don’t communicate clean information about real-world expectations of default probabilities.

  4. Ben says:

    It seems to me that point 6 is a deal breaker – allowing parties to buy an option on a failure, where the trigger for the failure is the increased price of the option…the CDS market would have to be very different to avoid this problem.

  5. Pingback: FT Alphaville » Further reading

  6. Yehuda says:

    #6 seems very problematic to me as well.
    Go short on a firm and then buy its CDS. A sensible strategy if you’re extremely pessimistic on the firm, but the trigger would give you an added incentive to pile on CDS in order to force the firm into default/into offering new equity and making you a pile of money on your short.

    Its a nice, clean, non-fraudulent way for anyone with serious resources to trash a firm and make a pile doing it. A big problem.

  7. Pingback: CDS and Market-Based Resolution, II « Rortybomb

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