Financial Instrument Equivalents That Don’t Turn Out to Be Legal Equivalents

The front page of the Wall Street Journal, Nov. 3, 2008, has a very important, very well researched and reported, story (I think it’s behind the WSJ subscriber wall) on the breakdown of AIG’s risk models that led not so long ago to its collapse and rescue by the US government – tens of billions of dollars have poured into AIG so far, and there is not really an end in sight as yet.  The story is a global one because, of course, the funds supplied to AIG came from global sources, AIG is operationally a global insurer based out of NY, and the insurance coverage that AIG supplied was to a global market.  (Carrick Mollenkamp, Serena Ng, Liam Plevin, and Randall Smith, “Behind AIG’s fall, risk models failed to pass real world tests,” WSJ, Nov. 3, 2008, p. A1.  Great research.)

The point in passing I want to make is a few paragraphs into the article:

AIG relied on those models to help figure out which swap deals were safe. But AIG didn’t anticipate how market forces and contract terms not weighed by the models would turn the swaps, over the short term, into huge financial liabilities. AIG didn’t assign Mr. Gorton to assess those threats, and knew that his models didn’t consider them. Those risks have cost AIG tens of billions of dollars and pushed the federal government to rescue the company in September.

The insurance issued by AIG against the possibility of default on the mortgage securities, in other words, were understood by the finance people and their models in one way – but, as it turns out, not in the way that the contracts actually said.  The words in the contract actually said something else.

And if you look back across various market disasters, you can see other situations in which the financiers thought the financial instruments were one thing, but when you actually had to read the contract, it said something different.  E.g., Roger Lowenstein, in his wonderful book on the collapse in the late 1990s of Long Term Capital, notes that the finance people at the hedge fund seemed not to have noticed that the standard swap agreement, into which they had entered in notional amounts around a trillion dollars but in very pint sized bits all designed to hedge each other to a neutral risk position, contained a standard cross default term.  In other words, default on one and you’re automatically in default on them all – and your risk position has gone from neutral to, well, over the rainbow.  A lawyer asked to read the agreement might have noticed the discrepancy between the words on paper and the assumptions of the financial engineers.  Maybe, maybe not.

For that matter, one of the most mundane of securities – preferred stock – also has something of this.  It is used as a financial proxy for debt, with a fixed dividend treated for most financial purposes as a fixed income stream equivalent to interest.  That’s true – but it isn’t that way once you reach bankruptcy, for example.  It still is a form of stock, not debt, as a legal matter.

As with many of these instruments, the equivalence is just fine – until a crisis hits.  Then, when you move from routine to meltdown, someone has to read the contract.  For that matter it might not be a contract – after all, equity is governed by corporation law which, despite all the inroads of contract law doctrines, remains historically rooted in agency, not contract.  And then you may well discover that precisely at the crisis margin is where the security does not behave as the equivalent the financial engineers thought it was.  It veers into something different precisely at the most difficult moment.  Nor is this simply some accidental feature of the instrument – preferred stock has its features, for example, including its priority in bankruptcy or its place on the balance sheet, for particular reasons.

I think we will see more examples of this emerge in the global credit crisis.  The thought that these instruments are not always legally what they are assumed to be financially has large implications for things like valuation – in which one technique is to price according to presumed equivalents – and really any attempt to establish financial proxies of one thing for another.

I’m thinking about an article to write next year on this topic, and if anyone has suggestions of other financial instruments of which this mismatch is true, I would be grateful to hear of them.  The article will, of course, be something of a plea for full lawyer employment – make sure someone has actually read the underlying contract as written in words.