Papagianis, Zingales on CDS Resolution Reform

Apr.16.10 | About: iShares U.S. (IYF)

Christopher Papagianis at Economics 21 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 (OTC:LEHMQ) 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 get 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?