Why Exempt Derivatives?

Includes: CIT, GS
by: Deep Value Guy

Goldman Sachs (NYSE:GS) has done it again, deftly navigating markets to maximize its own returns and leave others nursing losses.

The deal in question is a loan Goldman made to the troubled lender CIT (NYSE:CIT). The loan was dressed up as a derivative, which means Goldman can extract payments it is owed outside of the normal bankruptcy process.

Nothing wrong with that; Goldman has made another great trade. But is the exemption it exploited worth closing?

At issue is the integrity of the bankruptcy process.

By calling a time-out on creditors, bankruptcy offers the opportunity to reorganize and rehabilitate troubled companies, which is often in creditors’ best interest. A debtor’s assets often have more value if they keep generating cash flow, if the company in question continues as a going concern.

But if certain creditors get to pick off assets when a time-out is called, bankruptcy itself may be undermined. Such is the luxury of holding derivatives, which thanks to a 2005 bankruptcy reform, are exempt from the automatic stay that prevents creditors fleeing with their cash. Derivative holders also enjoy netting and close-out privileges that aren’t available to other creditors. And as we learned in the Lehman bankruptcy, derivative traders may make off with cash that isn’t rightfully theirs, forcing other creditors to chase them down.

Because Goldman’s loan to CIT was structured as a derivative — specifically, a “total return swap” — Goldman’s claim won’t be stayed along with others’ if CIT files for Chapter 11. The filing would trigger a $1 billion payment to Goldman.

Spying an opportunity to arbitrage regulation, smart lenders are doing the same as Goldman, structuring loans as “swaps, currency exchanges or securities deals,” according to bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges. Many are doing whatever they can to “put transactions beyond the control of bankruptcy courts.”

Why exempt derivatives from bankruptcy rules? A chief reason, according to proponents, is systemic risk. Derivative markets are just too volatile. You can’t force traders to sit on their positions through a lengthy bankruptcy process without breaking the daisy chain that connects counterparties.

First off, according to a paper by Robert Bliss and George Kaufman, it’s possible that the protections afforded derivatives actually increase systemic risk.

But for the sake of argument, let’s assume they’re necessary. Then we have another case of the tail wagging the dog, of reorganizing our financial markets around the needs of derivatives traders.

For what? The increased “liquidity” that derivative traders are so fond of reminding us they provide? CIT might not have been able to secure extra financing a year ago had Goldman not been able to structure its deal as a derivative. But maybe that would have been a good thing. If a company can’t secure financing via conventional lending sources, that’s probably a great sign the balance sheet needs to be restructured.

And I wonder: has total liquidity, in fact, increased? If conventional lenders see that their claims are increasingly superseded by derivative deals, will they be less inclined to offer financing?

In the end we could end up with another race to the bottom as bad financing options chase away good ones. Borrowers may sacrifice the protection of bankruptcy tomorrow for cash needed to survive today.

The CIT loan illustrates the need for change. To be sure it would be too disruptive to roll back the bankruptcy exemption for derivatives all at once. Still, it’s yet another reason we must shrink the derivatives market dramatically. Increasing capital requirements and migrating trades to exchanges would be a good place to start.