Prof. Jayanth R. Varma's Financial Markets Blog

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

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Sat, 22 Aug 2009

Winding up Lehman Europe

While much has been made about the difficulty of winding up large and complex financial institutions, it appears that it is the simplest of structures that are the hardest to wind up. Giving some of one’s things to another for temporary safe keeping on “trust” is probably older than lending money (debt markets) or selling equity interests in assets (stock markets) – it is probably older than money itself. Yet it is the simple trust structure that is proving so difficult with Lehman Brothers International Europe (LBIE) in London.

The UK High Court has ruled that the normal scheme of arrangements in bankruptcy do not apply to trust property:

51. On analysis Part 26 is concerned with the general estate of a company. It cannot override ordinary trust principles. In the case of creditors, whether actual, prospective or contingent, it deals with persons who have claims which they can bring against the pool of assets which comprises the general estate of the company. A creditor’s claim ranks pari passu with other creditors’ claims against that general estate. It is perfectly comprehensible, therefore, that Part 26 should provide that if those creditors wish to rearrange or compromise their rights against the company, they should be able to do so, by the requisite majorities, because, at the end of the day, they all look to the company’s assets for satisfaction of their pecuniary rights.

52. By contrast with that is the person who has placed his assets with a trustee. There the position is totally different: the essential feature of so doing is that the owner knows that he can have his property, which remains his throughout, dealt with by the trustee in accordance with the terms of the trust. The property is not vulnerable to interference merely because the trustee becomes insolvent: the trust remains. The fact that the trustee is a corporate trustee is likewise immaterial to the integrity of the trust; no less immaterial is that the trustee happens to be a company liable to be wound up under the Insolvency Act 1986 (or the equivalent provision in Northern Ireland), these being the types of company to which the court’s jurisdiction under Part 26 applies where a compromise or arrangement is proposed between a company and its creditors or any class of them: see section 895(2)(b).

53. The fact that the proposed scheme is confined to persons who have a pecuniary claim, however prospective or contingent that claim may be (for example a claim for damages or compensation for the delay in returning that person’s property), does not assist the administrators. While the existence of that claim may provide the basis for a scheme of arrangement directed to that and other pecuniary claims against LBIE, it does not justify interference with the underlying property rights of the property owner. Aside from the fact that the property owner’s remedy (as beneficiary under the trust) for breach of trust is principally directed to securing performance of the trust, rather than to the recovery of compensation or damages, the existence of the pecuniary claims does not affect, and is certainly not the origin of, the owner’s property rights. To suggest otherwise and to ground the intention of the scheme to interfere with the owner’s property rights merely because that owner also has a pecuniary claim against LBIE in view of the possibility that LBIE has acted (or may yet act) in breach of trust is to invert the position. Indeed, the scheme, if it is allowed to proceed, risks turning the position of the beneficial owner on its head: this is because under a trust it is for the trustee to justify and account for his dealings with the trust estate whereas under the scheme the onus will be on the owner to come forward, as a dissentient, to explain and justify why that owner’s property rights should not be dealt with and varied under the scheme.

What I found most amusing was the idea that when a hedge fund gives collateral to a prime broker with unlimited right to rehypothecate, “the owner knows that he can have his property, which remains his throughout.” But then I am not a lawyer.

The court of course thinks that the absence of a scheme of arrangement does not matter. The court has enough powers to sort things out. By that argument, one does not need a scheme of arrangement for creditors either – the courts can sort that out too.

77. Establishing what client assets of any given client LBIE holds or controls, what competing claims there may be to those assets by other clients or by LBIE (or others) and how LBIE and the administrators are to discharge their duties in respect of those assets with a view to their due distribution to those entitled to them are all matters where the court has, in the exercise of its trust jurisdiction, well-developed processes to assist the accountable trustee or other fiduciary. For example, the court is well used to authorising a trustee to make distribution of a fund where there can be no certainty that all of the claimants to it have been identified and the trustee desires the protection of a court order in the event that a further claimant should subsequently appear or matters subsequently come to light which question the basis on which the distribution is made. In one sense, dealing with the matter by recourse to the court’s assistance in this way can be simpler (and less costly) than the often complex processes involved in the promotion of a scheme under Part 26.

78. At the risk of appearing glib, I do not consider that a structured approach of this broad kind is beyond practical achievement in the exceptionally difficult circumstances of LBIE’s administration.

In short, it appears that the legal system in the foremost financial centre in the world does not have a practical way of dealing with the simplest and oldest financial contract – property held under trust.

Posted at 14:48 on Sat, 22 Aug 2009     View/Post Comments (0)     permanent link


I wrote a column in the Financial Express today about the role of securitization.

The global financial crisis began two years counting from the first liquidity crisis in Europe and the US on August 9, 2007. Over these two years, we have found that many of the conclusions that we came to in the early days of the crisis were simply wrong.

In 2007, we thought that the problem was about subprime mortgages, that it was about securitisation and that it was about CDOs (collateralised debt obligations). Now we know that these initial hasty judgments were mistaken. Defaults are rising in prime mortgages, huge losses are showing up in unsecuritised loans, and several banks have needed a bailout.

In 2007, when the first problems emerged in CDOs, people thought that these relatively recent innovations were the cause of the problem. Pretty soon, we realised that a CDO is simply a bank that is small enough to fail and conversely that a bank is only a CDO that is too big to fail.

Both banks and CDOs are pools of assets financed by liabilities with various levels of seniority and subordination. As the assets suffer losses, the equity and junior debt get wiped out first, and ultimately (absent a bailout) even the senior tranches would be affected. In retrospect, both banks and CDOs had too thin layers of equity.

Over the last two years, our understanding of securitisation has also changed significantly. As global banks released their results for the last quarter, it became clear that bank losses are now coming not from securitised assets but from unsecuritised loans or whole loans.

The Congressional Oversight Panel (COP) set up by the US Congress to “review the current state of financial markets and the regulatory system” published its latest report a few days ago. The report focuses entirely on whole loans and paints a very scary picture. Losses on troubled whole loans in the US banking system are estimated to be between $627 billion and $766 billion.

The COP report also states that “recent reports and statistics published by the FDIC indicate that overall loan quality at American banks is the worst in at least a quarter century, and the quality of loans is deteriorating at the fastest pace ever. The percentage of loans at least 90 days overdue, or on which the bank has ceased accruing interest or has written off, is also at its highest level since 1984, when the FDIC first began collecting such statistics.”

It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.

Potential losses on loans could be hidden and ignored for several quarters until they actually began to default. Losses on securities had to be recognised the moment the market started thinking that they may default sometime in the future. Securitised assets were thus the canary in the mine that warned us of problems lying ahead.

Until recently, it could be argued that securitised loans were of lower quality than whole loans and that at least to this extent securitisation had made things worse. But this statement is true only for residential mortgages and not for commercial mortgages, where the position is the reverse. Securitised commercial mortgages (CMBS) are of higher quality than whole loans.

The COP report states: “While CMBS problems are undoubtedly a concern, the Panel finds even more noteworthy the rising problems with whole commercial real estate loans held on bank balance sheets. These bank loans tend to offer a riskier profile as compared to CMBS, suggesting high term default rates while the economy remains weak.”

Two years into the crisis, therefore, we find that the initial knee-jerk reaction against securitisation was a big mistake.

Securitisation doubtless redistributed losses throughout the world so that losses from the US real estate emerged in unexpected places – German public sector banks, for example. But securitisation was not responsible for most of the losses themselves.

We must also remember the US home owner gets a bargain that is available to few home owners elsewhere in the world – a 30-year fixed rate home loan that can be repaid (and refinanced) at any time without a prepayment penalty. This is possible mainly through securitisation and deep derivative markets that allow lenders to manage the interest rate risks.

In India by contrast, the home owner gets a much worse deal: most home loans are of shorter maturity (20 years or less) and are usually either floating rate or only partially fixed rate. The few ‘pure fixed rate’ loans involve stiff prepayment penalties when they are refinanced. It would be sad if we keep things that way because of an irrational fear of securitisation.

Posted at 10:16 on Sat, 22 Aug 2009     View/Post Comments (9)     permanent link