The Effect On Bank Profits Of Poor Contracts

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The quality of contracts that banks trade is a driver of bank profitability.

The timely Nobel Prize in Economics focuses on the importance of contract economics.

This second article discussing bank-traded contracts discusses the changing function of collateral.

In OTC derivatives trades, growing regulation is shifting collateral ownership.

Just remember darling all the while, you belong to me.

- Patsy Cline

Following the award of the Nobel Prize for Economics to two contract theorists, Bengt Holmström and Oliver Hart, I have begun a discussion of the growing, significant, negative, role of poorly framed contracts in financial markets and institutions. This is the second installment. Here is the first.

The purpose is to describe the reasons why financial institutions should reconsider the current derivatives contracts that form the backbone of modern dealing profitability and risk, in order to improve derivatives' failing profit/risk tradeoff.

The banks cannot look to their regulators to solve their problems. Regulators, by Congressional mandate, focus only upon risk. Regulators will simply penalize entry into poorly framed contracts by requiring financial institutions to carry added capital due to the risks resulting from contract failure. Thus, the profitability of these contracts will fall, perhaps leading to curtailing their use.

This article asks a question that I have not seen discussed elsewhere. Is collateral still really collateral in the brave new world of OTC derivatives, post-Crisis? The locus of collateral is gradually being shifted in favor of the party that controls it, and against the party that "owns" it. The effect on the status of trader collateral is salutary in understanding contract quality. And its changing nature is damaging dealer bank trading profits.

In a thoughtful comment following my last article, Martin Lowy reminds us of the importance of contract duration in assessing contract quality. He notes that a shorter contract is a "better" contract, for the reason that, with short-duration contracts, there is a reduced opportunity for events unexpected by either party that drive the parties into litigation.

Translating that thought into the world of derivatives contracts and markets requires a few alterations to preserve Lowy's point in a derivatives environment.

Collateral in a "good" contract. Financial futures

One reason financial futures are "good" contracts, is that they are, in effect, "executed" daily.

A seller of a CME (NASDAQ:CME) gold futures contract, for example, may hold a commitment to deliver gold to CME in March until the contract "expires" in March. But each day, the buyer and seller pass the day's gains and losses from changes in the anticipated March value of gold through the clearing house, leaving neither party at risk to events other than those occurring during the next business day. In effect, buyers and sellers enter a new contract once a day.

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Collateral, or in exchange parlance, margin performance bonds, is limited to liquid instruments such as short-term Treasury securities. Customers are required to deliver collateral in support of their futures position risks. This collateral is the customer's property - subject to the control of the exchange, in the limited sense that the exchange may deduct the value of customer losses during the day from collateral after the close. In the event that the customer wants to reclaim control of her collateral, she offsets her positions (for example, buying sold positions back) and reclaims her collateral the following business day. The exchange calculates required collateral by considering the likelihood of a change in the futures price in a given day.

The point, however, is that no stretch of the imagination is needed to assert that the collateral is being managed by its owner, the exchange's customer. If the customer has put the collateral at risk on Monday, there is no problem retrieving it, adjusted for Monday's gains and losses, on Tuesday.

Collateral on a loan

Consider a more common example, the status of the collateral assessed by the creditor in a loan agreement. Normally in a loan agreement, the lender requires the borrower collateral assets with a value related to the credit quality of the borrower and the liquidity (marketability) of the collateral. In a loan agreement, if the debtor chooses to pay the loan amount outstanding, the creditor returns her collateral. Thus, there is a simple procedure, established in advance of the deal, by which the debtor can recover her collateral.

These days, though, the process of collateral recovery may be less straight-forward than recovering futures collateral. The lender may have sold the loan, re-pledging the collateral to a third party, something that the borrower would not approve if asked. The result will be that collateral recovery may be time-consuming. Furthermore, the borrower will learn the unpleasant fact that control of the collateral was in the hands of a third, untrusted, party. So borrower's collateral in this case is less "hers" than she thought. But the borrowers of the world have apparently accepted this change.

The bottom line though, is that at the beginning of the loan agreement, the borrower knows exactly how to recover her collateral at any time, if that is her choice. Thus in that sense, she owns it.

Collateral in a "bad" contract. Over-the-counter derivatives

As with the last article on contract economics, I will use the interest rate swaps (IRS) markets as an example of practices in the OTC derivatives markets. IRS counterparties enter an agreement that involves a commitment on the part of both parties to make payments into the distant future. The average maturity of an IRS is about five years.

The problematic factor that IRSs introduced into the world of contracting is that there is no exit from a swap. You may "assign" your position in a swap contract to a third party (called "novation") with the permission of your counterparty - but that permission is rarely forthcoming. You can also "buy back" your contract from your counterparty - but you have no leverage in negotiating the buy-back price - with the result that the price is usually punitive.

That fact raises a question about the ownership status of the collateral associated with a swap agreement.

Normally the collateral associated with an IRS is determined much like the collateral associated with a futures contract. The counterparties come to an understanding about the likely future changes in the value of the swap. Each party collects a similar amount of collateral when the contract is agreed. There are further conditions that give each counterparty the right to demand more collateral if the value of the IRS moves in her favor.

Do I own my collateral if I enter an OTC derivatives trade?

To what degree is my collateral in an interest rate swap still mine? Since I cannot terminate an interest rate swap agreement, there is no way to recover control of the collateral until the swap expires in five years. Further, under unpredictable circumstances specified in the swap agreement, my counterparty may demand more collateral. If I don't comply, the swap agreement is terminated, since failure to increase collateral on demand is an act of default.

What happens to the collateral associated with a swap agreement in an act of default? The swap in question will be cancelled. This gives my counterparty the right to decide for herself the value of the swap and the value of the collateral. If the counterparty finds that the value of the swap exceeds the value of the collateral (in her sole opinion), my counterparty may seize the collateral. In addition, all other derivatives trades, with all other counterparties, are cancelled upon this single act of default. Each counterparty may separately determine how much of my collateral is theirs and seize it, without any judicial intervention. Bye.

In other words, not only is my ownership of the collateral I have surrendered each of my swap counterparties doubtful, but my ownership of liquid assets still under my control is doubtful as well.

To Clear or Not to Clear

The issue of collateral security depends greatly upon whether an interest rate swap has been cleared through LCH:Clearnet (a cleared swap) or is an agreement with financial institution (a bilateral swap.)

The protection of collateral is substantially enhanced by clearing the swap. Say I have a swap with Bank A. Once I have cleared the swap, it is not a swap with Bank A, but a swap with LCH:Clearnet.

My ability to force a change in my counterparty from Bank A to LCH:Clearnet has the effect of making an exit from the swap by novation easier. I still require the permission of my counterparty, LCH:Clearnet, to novate the swap; but LCH:Clearnet will agree, as long as the payments are unchanged and I replace myself with an LCH:Clearnet clearing member. Thus, I can negotiate my swap's value with any of the dealing banks, allowing competition to work its magic.

But most bilateral swaps are bilateral swaps because the customer side of the trade wants to use deferral accounting to value the swap, an option that will not be available once the swap is cleared, since LCH:Clearnet will assess margin payments as market values change. Hence, clearing of bilateral swaps is more a means of escape from the unduly binding effects of a swap contract the customer regrets entering, than a routine measure for managing collateral calls.

But I believe the courts have a pretty good case for challenging the ownership status of OTC derivatives "collateral," should a non-dealer counterparty dispute ownership of collateral. This issue grows ever more important, as bank regulators are requiring more collateral of bilateral counterparties in coming years.

Regulators are steadily downgrading the utility of bank services by reducing the value of the products banks have offered other than loans. And, worse, it is no secret that the profitability of the loans that fire the imagination of bank regulators has been declining continuously for decades, as borrower access to non-bank, market-based sources of credit has grown. This is a prescription for the growth of non-bank financial institutions, where the energy of innovation remains undiminished. Not the outcome regulators expect or desire.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.