In Part one, FT Alphaville asked whether there was reason to doubt the netted derivatives exposures reported by banks. Here, we discuss how netting works (or doesn’t, ahem) when counterparties collapse.

Valuing swaps when the world is crumbling

Derivatives expert Satyajit Das recently provided a comprehensive overview of the difficulties experienced in valuing and closing out swaps for which Lehman was a counterparty. Nevermind netting for a moment, valuation is the step before that, and it has proved incredibly challenging to resolve.

Part of this is a function of how distressed the market was when Lehman filed for bankruptcy, but another is about deciding what discount rates should be applied. Yes, humble discount rates can be that challenging. And that’s just a part of the lengthy and complex dispute.

Here, a lecturer at Stanford Law School (and former managing director of Lehman Brothers) extols how great it was that the process took only three years to resolve (in contrast to the well-managed institution known as Enron that took 10 years — but we’re failing to see how either is a crowning achievement):

Under the terms of the ISDA Master Agreement, the governing contract for virtually all derivatives transactions, the non-defaulting counterparty calculates the amounts owed upon termination. Here, the estate decided that the defaulting party should rely on a standardized methodology to value remaining derivatives claims.[14] Ultimately, then, the largest bankruptcy filing in U.S. history has shown that resolution can be achieved in just over three years, and that derivatives caused the largest enhancement to the bankruptcy estate.

(Let it slide that there are still plenty of Lehman cases in the courts.)

And concerning the “enhancement”, assuming that what Lehman got is “fair” (it’s subjective of course), why is it so great that it took the estate three years and huge arguments to get what should have been theirs all along? And why is it implicitly good that Lehman’s derivatives assets out-stripped any boost to creditors from actual cash asset holdings?

In case you’re wondering how much was tied up in this, here’s what Risk wrote in March of this year:

More than two years after the bankruptcy of Lehman Brothers Holdings Inc (LBHI), administrators are still trawling through tens of billions of dollars in unresolved derivatives claims. The process has been slow and litigious – just $5 billion of claims have so far been settled, representing 11% of the total, according to Alvarez & Marsal, the administrators for LBHI. At this pace, it is estimated the process will stretch on until at least 2016.

Newsflash: not all legal systems are the same

Another reason to be cautious about netting is that there’s a lot of variation in the treatment of swaps between jurisdictions when one of the counterparties has defaulted.

There’s a case in the Court of Appeals in the UK right now that’s actually several different suits lumped together (and not all involve Lehman). At the heart of it is whether the non-defaulting counterparty has to perform under a swap contract governed by an Isda Master Agreement (that governs most swap transactions). “Perform” meaning continue to pay or to close out at fair value — provided you can agree what that is, of course.

Courts in the UK have previously ruled that non-defaulting out-of-the-money counterparties don’t have to payout to the parties they are facing if said party is in default, e.g. bankrupt. Furthermore, if the defaulting party cures their default but the swap has already expired, the party that never defaulted never has to pay.

This hole in the Master Agreements is being knitted shut by Isda, but it won’t affect existing contracts, unless a special protocol is issued.

Of what value, is this netting?

Given all of this, take a look again at the derivatives disclosures of Bank of American and Goldman Sachs from Part one and ask, “what value does netting have?” The cash collateral held is probably a good mitigant, but you won’t know how much is definitely yours until you agree on valuation. Evidently figuring that out in three years is considered fast. But true, you’ll probably have some ballpark. So collateral, provided it doesn’t tank in value at the same time that your counterparty goes down, is a winner.

But what about the other half of the derivatives exposures that aren’t covered?

Bank of America: 1 – [66  / (2,172 - 2,027)] = 54 per cent
Goldman Sachs:  1- [122  / (1,060 - 846)] = 43 per cent

Well, let’s just hope that those are transactions facing less risky counterparties, like sovereigns (who traditionally don’t post collateral at all, by the by).*

And it’s also good that Isda’s got the puncture kit out for jurisdictions that have reached conclusions on Master Agreements that the trade body finds undesirable.

But getting back to Snider’s argument (as detailed in Part one) for a moment, imagine all of the energy that goes into the world of synthetic exposures was instead applied to the real economy. The abstract world of derivatives sure does take a hell of a lot of looking after.

Derivatives have some place in allowing widget-makers to better manage their risks. Though we have doubts that much of the $106,523bn of additional notional exposures — as a proxy for market activity — from the six months to June 2011 was down to demand from them.

* We ♥ pedants, so just for you: Portugal and Ireland do post collateral these days.

Related links:
Finance Now Exists For Its Own Exclusive Benefit – Real Clear Markets
Satyajit Das: In the Matter of Lehman Brothers – Part 1: Breaking Up is Hard To Do – Naked Capitalism
Satyajit Das: In the Matter of Lehman Brothers – Part 2: Well Structured Messes – Naked Capitalism
Court approves Lehman pay-out plan – FT (December 6th, 2011)
Derivatives industry eyes UK Lehman appeal ruling – Reuters
Lehman, Metavante and the ISDA Master agreement - FT Alphaville (2009)
LBHI administrators push for settlement of derivatives claims – Risk