Why privilege derivatives?

October 6, 2009

Goldman Sachs 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. 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.


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Yes it is another reason to shrink the derivatives market. The derivatives are a pure gambling tool. They need to be much more strictly regulated and severely limited. Most, of course, need to be not allowed for future investments.Money put into derivatives does not go into infrastructure orindustrial capacity, ipso factor, it’s a “bad thing” for the world economy and 99+ per cent of the world’s inhabitants.

Posted by Bob Miller | Report as abusive

Call me socialist but financial markets must be built around needs of real economy and society. I am fine with traders making excessive profit from their activities as long as it doesn’t affect the rest of us.For lost 2 yrs we saw spectacular abuse of society by financial sector. Financial sector doesn’t provide foundation for stable growth. On contrary it became tool of extortion that leaves the rest of economy straggling for survival.People who were in center of these events walk away with salaries and bonuses. I am talking about traders, executives, brokers and financial annalists. 1,000,000s people who had nothing to do with financial sector suffer badly – they lost jobs, saving, houses etc.America always pretended to be built about justice. Now we see that even justice is being hijacked and abused by greed. I survive after all I a work for finance :).

Posted by Sergey | Report as abusive

Where there is a winner, there is a loser, and if I recall correctly, some Chinese traders are not happy at all with the outcomes. Let’s restrict it to Goldman Sachs and CIT though – are you sure that they are preferential creditors ? Normally there is a whole queue, especially the IRS, before we move on to subordinated debts and the rest.’Increasing capital requirements and migrating trades to exchanges would be a good place to start.’ – good idea to get cash in, but are these not traded on exchanges, with its own rules already ?

Posted by Gaspard | Report as abusive

I think there is a need to revamp the entire banking system. The use and abuse of the systems by insiders to make money is crazy. The sub prime crisis is still hanging on our necks. We should start the revamp soon to make sure that those fat cats of the financial sectors slim down soon

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[…] 1, 2009 · Leave a Comment A woman called police to report that she was driving […]

Posted by Now that’s drunk… « Bob Morris: Investing, tech, coffee. | Report as abusive

>>> derivatives are a pure gambling tool.

Wrong. Gambling is creation of new, artificial risks. It apparently doesn’t bother you when folks do that in Las Vegas, or in office football pools.

Derivatives are the instrument by which one party assumes someone else’s risk, in exchange for payment received. Fundamentally the same as health insurance or fire insurance.

No one was held at gunpoint and forced to sign papers with Goldman Sachs. They did these deals because they wanted high rates of return. Now they’ve lost their retirements because they were too greedy, and asleep at the wheel. GS wasn’t asleep at the wheel.

We can also note that even guys who ===were== outright dishonest, like Bernie Madoff, didn’t use advertising. They got their suckers by word of mouth from other “satisfied customers”, apparently mostly from within his own ethnic circle. Famous, prestigious people like Elie Weisel lost millions becuase they never did basic due-diligence. In 20-20 hindsight, we now now that those who did even rudimentary due-diligencing on Madoff, who telling anyone who would listen that this was a rotten fish.

If Eli Weisel had bought a used yugo, then complained afterwards that it isn’t “just like” the BMW as he was promised by the used-car salesman, you wouldn’t have much sympathy for him.

So why should we have sympathy for his financial losses which followed from his zombie-like devotion to a snake-oiler peddler?

The folks and the outfits who lost big bucks to Goldman Sachs, all had accountants and lawyers handy. If they weren’t too cheap to pay for a basic investigation of the risky paper they were lining up to buy, they wouldn’t have gotten hurt.

Posted by al | Report as abusive

[…] cut in line in front of all of the bankruptcy creditors to get paid (and see this and this). In other words, there are other problems caused by CDS other than destabilizing the economy as a […]

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