Pirrong on the CME and Lehman

By Felix Salmon
April 15, 2010
Craig Pirrong has a thoughtful response to the unredacted Valukas report on the CME and Lehman, and in particular to my take on it. He explains clearly the reasons why Lehman's CME positions were sold for $1.2 billion less than their market value:

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Craig Pirrong has a thoughtful response to the unredacted Valukas report on the CME and Lehman, and in particular to my take on it. He explains clearly the reasons why Lehman’s CME positions were sold for $1.2 billion less than their market value:

Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy. Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions. Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process. In these circumstances, it was inevitable that firms would assume these positions only at discounted values.

So given all that, why did the CME auction off the positions? Because if it hadn’t, then it was theoretically possible that Lehman’s margin positions might not have sufficed to cover the losses associated with the positions. And in that case the CME would have become a Lehman creditor, and it didn’t want to risk that. Pirrong writes:

Clearing does not make risk disappear. The experience of CME with the Lehman situation shows that clearly. Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system. It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

It’s undoubtedly true that moving risks onto a clearinghouse increases the amount of risk which is in the clearinghouse. That’s a feature, not a bug, since the clearinghouse is focused, daily, on managing its tail risk. Because clearinghouses don’t trade daily, and don’t have a daily P&L, the tail risk is the one big risk they have to manage.

And yet when finally faced with such a risk, in the wake of Lehman’s failure, the CME’s reaction was to panic and spend any and all of Lehman’s collateral just to get the risk off its own books and somewhere — anywhere — else.

The point here is that the CME was incredibly cavalier with other people’s money, the minute those other people went bankrupt. If it had held onto the positions and they ended up being wound up or expiring at a profit, then the collateral would not have gone to the CME, it would have gone back to the Lehman estate. So the CME had no incentive to do that. Instead, it seized the collateral and threw it at Goldman Sachs, Barclays, and DRW Trading. It wasn’t the CME’s money, and it surely made those major CME clients very happy, so everybody wins. Except Lehman, and who cares about them — they’re bankrupt.

Here’s Pirrong:

The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity. That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.

Actually, the CME was trying to protect itself from any possible negative effects of a Lehman default, despite the fact that it possessed of billions of dollars of Lehman’s money: the mere existence of the CME helps to protect other clearing members from the counterparty risks associated with something like a Lehman default. That’s why central counterparty clearing is a good thing. The CME, however, was happy to pay out $1.2 billion of Lehman’s money to insulate itself from tail risk. Which is a very large sum of money. As Valukas says, there’s a colorable claim there from Lehman’s creditors.

7 comments

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As I remarked in response to your first post, in a comment similar to Pirrong’s, the CME did exactly what it is supposed to do – what it ought to be required to do by law if it isn’t already. There is absolutely no way a central counterparty should be taking on risk on the off chance of saving a few bucks for some creditors – the downside isn’t just a loss for the exchange, but collapse of the financial system.

I certainly hope there isn’t a “colorable claim” against the CME, because if there is then the current movement to put OTC derivatives onto central counterparties will vastly increase systemic risk.

Posted by Greycap | Report as abusive

The more I think about this, the less tenable your position seems to me, Felix. You say “only six firms were invited to bid” – so what do you want, an invitation to bid sent out to the market as a whole? You’d have to expose your position to do that, and if you tell the market that you plan to dump a giant position, what do you expect to happen? Don’t you think the market would move against you? That’s not exactly a “tail risk”! And LHI’s creditors wouldn’t benefit anyway.

Posted by Greycap | Report as abusive

I think the better take-away here is that the CME did not margin LEH’s positions appropriately.

Posted by Sportello | Report as abusive

Why couldn’t the CME just ask LEH to reduce their positions? These positions were not just fully margined but there was excess margin at the exchange backing them. The preemptive strike of CME blowing out a position because they *think* that at some point there will not be cash available from LEH for further margin calls hence putting the exchange at risk seems very aggressive and unprecedented. Did they ask for more margin from LEH? Did they ask LEH to reduce their exposure? Did they have to pay people to take every position in every market at once or could it have been done more orderly? To me this feels like an exceptionally aggressive move by the exchange that did harm LEH. Obviously LEH had big problems but their exchange cleared derivatives positions were not one of them at the time they had it all taken from them.

Posted by anon60606 | Report as abusive

“Why couldn’t the CME just ask LEH to reduce their positions?”

It is not true that Lehman was somehow barred from selling down there position? Of course they would have preferred to close it out, and the fact that they couldn’t do it between Monday and Thursday is prima facia evidence that it couldn’t be done without creating a loss, and that therefore the result of the auction was fair.

“These positions were not just fully margined but there was excess margin at the exchange backing them.”

That is not true. Some positions were over-margined and others were under-margined. You could see this for yourself by actually reading the report.

“Did they have to pay people to take every position in every market at once or could it have been done more orderly?”

How exactly could the exchange execute a more orderly liquidation without assuming the position risk itself? That is something it has no right to do. The cost of getting GS et al to assume the positions was exactly the cost of finding someone to execute an orderly liquidation. Its not like anyone wanted the positions for their own sake.

“Obviously LEH had big problems but their exchange cleared derivatives positions were not one of them.”

Who cares what Lehman’s problems were? The problem to avoid was blowing up the CME. What the CME did is exact reason you have to post collateral in the first place! Not only did the process work as intended, it achieved the goal it was designed to achieve, and that goal was to protect not just the exchange but society at large. This episode is exactly what happens when the benefits of central clearing are realized as claimed.

What hope is there for “reform” of the financial system if most people can’t even recognize an example of a safe, well functioning system when they see one?

OK, I’ll calm down now. For a less heated rant, see what he said: http://streetwiseprofessor.com/?p=3637.

Posted by Greycap | Report as abusive

I think what the CME did was appropriate. The markets were extremely volatile during those days and the exchanges first move should be to protect the exchange.

It is important to note that I believe DRW liquidated the fixed income position rather quickly or atleast hedged and eurodollars had a 100 basis point sell-off that week in order to gain liquidity.

Posted by sditulli | Report as abusive

You still don’t quite get this, Felix, although you’re getting closer.

“Actually, the CME was trying to protect itself from any possible negative effects of a Lehman default, despite the fact that it possessed of billions of dollars of Lehman’s money: the mere existence of the CME helps to protect other clearing members from the counterparty risks associated with something like a Lehman default.”

Well, yes and no. Assume CME holds onto the positions in an attempt to secure a better deal for Lehman creditors, and assume the eventual losses exceed margin – who covers the addditional loss? The dealers, through the funds they provide mutually to CME’s clearing fund. And who would be asked to stump up additional capital to keep CME afloat if this was burned through? Again the dealers. Pirrong’s right here (and most other places).

A second point is that Lehman went into the clearing house with its eyes open – it knew that something like this would happen if it ever got into difficulties. Of course, that risk was no doubt mispriced, along with everything else, in the build-up to the crisis.

Having said that, there seems no doubt CME’s processes could have been better designed. Compare the arrangements of the London Clearing House in the UK, which had an established and tested auction facility.

Posted by MD4VB | Report as abusive