Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:
twitter
Facebook
Wordpress

April
Sun Mon Tue Wed Thu Fri Sat
        1
 
2010
Months
Apr
2009
Months

Powered by Blosxom

Thu, 01 Apr 2010

Prudent at night but reckless during the day

I have been thinking a lot about what the court examiner’s report on Lehman tells us about other banks. Looking at many things mentioned in the report, my conclusion is that even the banks that are prudent at night become quite reckless during the day. Banks that are careful about their end of day (overnight) exposures seem to be happy to assume very large exposures during the day provided they believe that the position will be unwound before close of the day.

My first example of this phenomenon is a repo transaction undertaken by Barclays after it bought a major part of the Lehman broker dealer business (LBI) in the bankruptcy court. The examiner describes this transaction and its consequences in detail in his report:

The parties then began to implement ... a repo transaction between LBI and Barclays under which Barclays would send $45 billion in cash to JPMorgan for the benefit of LBI, and Lehman would pledge securities to Barclays. Barclays planned to wire the $45 billion cash to JPMorgan in $5 billion components, and Barclays (actually, Barclays’ triparty custodian bank, BNYM) would receive collateral to secure each $5 billion cash transfer. (Page 2165, Volume 5)

Shortly after noon on Thursday, Barclays wired the initial $5 billion of cash to JPMorgan for the benefit of LBI. (Page 2166, Volume 5)

... a senior executive from JPMorgan then contacted Diamond, and asked Barclays to send the $40 billion in cash all at once to expedite the process. According to Ricci, the JPMorgan executive provided Diamond with assurances that, if Barclays sent the $40 billion in cash, JPMorgan would follow up promptly in delivering the remaining collateral. Early Thursday evening, Barclays wired the remaining $40 billion in cash. Barclays did not receive $49.6 billion in securities that evening. Although both the FRBNY and DTCC kept their securities transfer facilities open long after their usual closing times, by 11:00 p.m. on Thursday evening, September 18, Barclays had received collateral with a marked value of only approximately $42 billion. (Page 2167, Volume 5)

To put matters in perspective, $40 billion was roughly equal to the total shareholders’ equity of Barclays at that time (according to the June 30, 2008 balance sheet, shareholders’ equity was £ 22.3 billion or $40.5 billion at the exchange rate of 1.82 $/£ on September 18, 2008). In other words, Barclays was willing to take an unsecured intraday exposure to another bank equivalent to roughly its entire worth. I am sure that an overnight unsecured exposure of this magnitude would be regarded as reckless and irresponsible, but an intraday position was acceptable.

My second example is the triparty clearing bank services provided by JP Morgan Lehman and other broker-dealers. The examiner’s report provides a lucid explanation of the whole matter:

In a triparty repo, a triparty clearing bank such as JPMorgan acts as an agent, facilitating cash transactions from investors to broker- dealers, which, in turn, post securities as collateral. The broker-dealers and investors negotiate their own terms; JPMorgan acts only as an agent. Triparty repos typically mature overnight ... Each night collateral is allocated to investors ... The investors, in turn, provide overnight ... funding to the broker-dealer. The following morning, JPMorgan “unwinds” the triparty repos, returning cash to the triparty investors and retrieving the securities posted the night before by the broker-dealer. These securities then serve as collateral against the risk created by JPMorgan’s cash advance to investors. During the business day, broker-dealers arrange the funding that they will need at the close of business through new triparty-repo agreements. This new funding must repay the cash that JPMorgan advanced during the business day... (Page 1086-87, Volume 4)

The premise of a triparty repo is that it constitutes secured funding in which the lender (investor) has the opportunity to sell the collateral immediately upon a broker-dealer’s (borrower’s) failure to pay maturing principal. (Page 1092, Volume 4)

To guard against the possibility of the investor realizing less than the loan amount in a liquidation scenario, the borrower must pledge additional “margin” (i.e., additional collateral) to the lender – for example, $100 million of Treasury securities in exchange for $98 million in cash. (Page 1092, Volume 4)

As triparty-repo agent to broker-dealers, JPMorgan was effectively their intraday triparty lender. When JPMorgan paid cash to the triparty investors in the morning and received collateral into broker-dealer accounts (which secured its cash advance), it bore a similar risk for the duration of the business day that triparty lenders bore overnight. If a broker-dealer such as LBI defaulted during the day, JPMorgan would have to sell the securities it was holding as collateral to recoup its morning cash advance. (Page 1093, Volume 4)

Through February 2008, JPMorgan gave full value to the securities pledged by Lehman in the NFE calculation and did not require a haircut for its effective intraday triparty lending. Consequently, through February 2008, JPMorgan did not require that Lehman post the margin required by investors overnight to JPMorgan during the day. (Page 1094, Volume 4)

That last paragraph left me stunned. Why would the clearing bank not impose a haircut/margin on the intraday secured lending, while the repo lenders do require such a haircut on the overnight lending? It makes no sense to me. First, the clearing bank is taking a large concentrated exposure, while this exposure gets distributed over a large number of overnight lenders. If anything, the intraday lender should be more worried and should be charging a higher margin. Second, most financial asset prices instruments are more volatile when the markets are open than when they are closed. Since prices are expected to change more during the day than during the night, the intraday lender actually needs a higher margin. Yet, the intraday lender did not ask for any margins at all till February 2008!

For a moment, I thought that the clearing bank was not charging margins because it was willing to take some amount of unsecured exposure to the broker-dealer and it was willing to dispense with the margin under the assumption that the margin would be less than the unsecured exposure that it was willing to have. But no, the examiner’s report clearly states that the margin free secured lending was over and above the maximum unsecured lending that JPMorgan was willing to provide:

JPMorgan used a measurement for triparty and all other clearing exposure known as Net Free Equity (“NFE”). In its simplest form, NFE was the market value of Lehman securities pledged to JPMorgan plus any unsecured credit line JPMorgan extended to Lehman minus cash advanced by JPMorgan to Lehman. An NFE value greater than zero indicated that Lehman had not depleted its available credit with JPMorgan. (Page 1093, Volume 4)

Yet, on a reading of the entire examiner’s report, JPMorgan comes across as a bank with a very robust risk management culture. Again and again one sees that in the most turbulent of times, the bank is seen to be sensitive to various market risks and operational risks and appears to have taken corrective action very quickly. The only conclusion that I can come to is that even well run banks are complacent about intraday risks.

Why should banks be prudent at night but reckless during the day? Probably this has got to do with the fact that nobody prepares intraday balance sheets and so positions that are reversed before close of day do not appear in any external reports (and probably not in many internal reports either). Probably, it has to do with the primordial fear of darkness dating back to our evolutionary struggles in the African Savannah. As the biologists remind us, you can take the man out of the Savannah, but you can not take the Savannah out of the man.

Posted at 16:55 on Thu, 01 Apr 2010     2 comments     permanent link

Comments...

athreya wrote on Mon, 05 Apr 2010 12:21

Re: Prudent at night but reckless during the day

Prof Varma, that was an interesting observation. As someone working in a trading outfit, I can think of one explanation. Traders are wary of overnight positions because of the 'gaping risk' that is the market can open with a large gap from previous close due to events/developments in local/overseas economies post-market hours. Such a gap opening precludes the possibility of covering one's open positions or to cut losses. Whereas, any event or development unfolding during market hours, although it may lead to significant market movements and cause losses, at least provides traders with the opportunity of covering their open positions. It may be hubristic, but it boils down to perception of traders that when they are sitting in front of the trading screens, they will be able to assimilate and react to any new development sufficiently fast. This is just an anecdotal/behavioural explanation I can think of.

Nirav wrote on Tue, 06 Apr 2010 10:58

Re: Prudent at night but reckless during the day

I think it has also to do with trader's overconfidence on the liquidity of the markets. They feel they can dump their massive positions in no time, completely ignoring the impact costs.